When selling a business, the consideration received may be deferred and contingent on specific events.
This means the exact amount payable may be known (ascertainable) or unknown (unascertainable).
Understanding the tax implications of these different types of considerations is crucial for effective financial planning and tax management.
(Read Time: Approx. 5 minutes)
Topics Discussed:
- Tax implications of various types of deferred considerations.
- Importance of clear terms and professional advice in business sales.
Deferred Consideration and Earn-Outs
When selling a business, the consideration can be structured in various forms, such as cash, shares, or loan notes, and the timing and amount can have significant tax implications.
Here’s a detailed look at how different types of proceeds are taxed and what to consider during the sale.
Types of Consideration
Cash Proceeds
- Ascertainable: If the exact amount is known at the date of disposal, it is fully taxable at that time.
- Unascertainable: An estimated net present value is taxed, with any excess amount received later being taxable upon receipt.
Shares
Gains from shares can be deferred under share-for-share exchange rules, allowing for a more manageable tax schedule.
Securities
Gains from shares can be deferred under share-for-share exchange rules, allowing for a more manageable tax schedule.
Earn-Out Rights
- For Cash: Treated similarly to cash proceeds, with tax implications depending on whether the amount is ascertainable or unascertainable.
- For Shares or Loan Notes: These are deemed securities and can be deferred under share-for-security rules, helping manage immediate tax liabilities.
Deferred Consideration: Tax and Strategic Considerations
Cash and Deferred Cash Consideration
Tax is due on the full sale price, including any deferred cash, as per the principle in Marren v Ingles.
For unascertainable amounts, the best estimate is taxed initially, with adjustments made if the actual amount varies.
Share Consideration
Gains are deferred until the shares are converted to cash or disposed of, allowing flexibility in tax management.
Loan Note Consideration
Gains can be deferred until redemption of the loan notes, although changes in 2010 rules mean Business Asset Disposal Relief (BADR) is no longer available for deferred gains without an upfront election.
Special Considerations
Loan Repayments and Earn-Out Adjustments
Establishing the actual consideration for share disposal can be complex, as seen in the case of Michelle McEnroe & Miranda Newman v HMRC [2022].
The gross consideration from the Sale and Purchase Agreement (SPA) must be declared for Capital Gains Tax (CGT) purposes, not the net amount after loan repayments.
Mixtures of Consideration
Special rules apply, taxing components proportionately and necessitating careful planning to optimise tax outcomes.
Earn-Out Agreements
Cash Earn-Outs are taxable at the date of sale and may be contingent or ascertainable, affecting the taxable value.
Non-Cash Earn-Outs however, are treated as deemed securities, with potential for deferral under exchange rules, ensuring tax efficiency.
Negotiation is key, with terms often based on earnings, profits, or turnover. The structure should align with both short-term and long-term goals of the buyer and seller.
Structuring Earn-Outs for Maximum Benefit
Basis
An earn-out is generally based on a multiple of sustainable earnings, EBITDA, or other profit metrics relevant to the business.
This ensures the seller is compensated based on the business’s future performance, aligning interests between the buyer and seller.
Period
The earn-out period can range from six months to several years.
A shorter period may benefit sellers looking for a quick pay-out, while a longer period might be more attractive for buyers cautious about immediate cash flow.
Structure
Earn-outs can be structured in various ways, depending on the goals and intentions of the parties involved. For example:
- Retention of the Seller: Buyers may want the seller to stay on for a smooth transition, tying them to performance targets.
- Clean Break: Sellers wanting a quick exit might prefer upfront payments, even if smaller.
Cash, Shares, or Loan Notes?
Each form of consideration has its benefits and tax implications:
- Cash: Simplest form but may involve immediate tax liabilities.
- Shares: Offers potential for deferred tax but carries risk if the buyer’s company performance declines.
- Loan Notes: Deferred tax implications but can be complex to manage and convert.
Example of an Earn-Out Agreement
Consider a company valued at £10 million.
Mr. Buyer offers Mr. Seller £8 million upfront, with a £2 million earn-out based on performance.
The earn-out is structured as convertible loan notes, half convertible after one year if sales targets are met, and the other half after two years.
Top Tips for Sellers
Preserving BADR
To preserve Business Asset Disposal Relief (BADR) while deferring CGT, structuring the sale to receive consideration in cash or convertible shares rather than loan notes may be advantageous.
Professional Advice
Due to the complexity of tax implications, professional advice is crucial.
Ensuring the terms are clear and favourable requires expert guidance.
Summary
Selling a business involves navigating complex tax considerations, especially with deferred and contingent payments.
Professional advice is crucial to structure the sale for optimal tax efficiency and to avoid pitfalls like those in notable tax cases.
Are you considering selling your business? Ensure you maximise your proceeds and minimise tax liabilities by consulting with Ilyas Patel Accountants.
Our expert team can guide you through the complexities of deferred consideration and earn-outs, ensuring a smooth and financially advantageous transaction.
Contact us today at info@taxexpert.co.uk, or fill out our form here, to start your claim and include all relevant information.
For any questions, please give us a call at 01772 788200, or message us on our WhatsApp for out of office hours.
Kind regards,
Ilyas Patel