Arthur Conway CTA (Fellow) looks at a company disposal without taper relief.
This article appeared in the February 2003 issue of Tax Adviser.
Unprecedented numbers of businesses are being incorporated prompted by favourable rates of tax on dividends and corporate profits. Most of these new companies will stay in the same hands beyond two years. Inevitably, however, some will be sold sooner – causing some awkward tax problems. A new provision – of the Taxation of Chargeable Gains Act 1992 (TCGA 1992), s. 162A – now permits an election to counter the worst of these problems (the loss of taper relief where s. 162 rolls over gains on incorporation); early disposals however, especially those within a year, will still cause difficulties.
There is a particular danger in a first year disposal where the company has issued only a nominal amount of share capital and bought goodwill from the shareholder on a loan account. The objective here is to repay the loan out of post-tax profits over the few years following incorporation – this replaces taxable dividends or salary with a cash stream, tax free in the shareholders’ hands. There is of course ‘up front’ tax to this, in the form of capital gains tax (CGT)on any gain on the disposal of goodwill to the company – but where full business asset taper relief (BATR) reduces that tax to only ten per cent of the gain, who would grumble? This method of incorporation is seductive, and certainly worthwhile where the shares are held long enough for BATR on their disposal, but if the company is unexpectedly sold in the first year then it is likely to backfire. The reason for this is that cash drawn against the loan account cannot also be used for distributions – thus the payment of a pre-sale dividend (the standard tactic in the face of a full forty per cent gains tax charge) will be compromised. Indeed the paradox with this sort of incorporation is that the more cash extracted by the shareholder, the more his shares increase in value, and the harder it becomes to pay him a dividend.
Problem and solution
The following simplified example illustrates the problem and suggests an effective solution:
Mike traded for ten years then incorporated his business eight months ago when he subscribed for two ordinary £1 shares in Baldwin Ltd. The company traded from rented premises previously occupied by Mike, and bought his goodwill on loan account for £450,000 (professionally valued), it also paid (by overdraft) the book value for his trading stock (an election will be made under Income and Corporation Taxes Act 1988 (ICTA1988), s. 100(1C) .
The chargeable gain on the sale of Mike’s goodwill to the company was realised without benefit of base cost or retirement relief, but was reduced by maximum BATR. After his 2002–2003 annual exemption, Mike’s capital gains tax on the gain was £41,920. Mike was happy with this and eagerly looked forward to the £450,000 tax free drawings from his company.
During the company’s very successful eight months’ trading (in which business prospects improved substantially), all post-tax profits (£200,000) have been drawn by Mike against his loan account leaving Baldwin Ltd. in its present position namely: goodwill at cost £450,000 (no amortisation); loan balance £250,000; retained profits £200,000 (closing stock and debtors are matched by creditors and overdraft).
Mike has recently been approached with a cash offer. A substantial and reputable purchaser is willing to pay either £500,000 for the company’s share capital (followed by the guaranteed repayment of the loan balance), or £750,000 for its goodwill (subject to the transfer of key employee contracts). The purchaser insists on quick completion and won’t wait four months – Mike’s hopes of a sale with 50 per cent BATR seem shattered.
Mike starts looking for straws to clutch, and says he has heard that the taper ‘clock’ can be kept ‘ticking’ by a vendor accepting purchaser loan notes in exchange for target company shares. He suggests that this would secure full 75 per cent BATR by taking the gain on a redemption of loan paper after Baldwin Ltd.’s second ‘birthday’. It is explained to Mike that if the issue of loan paper is in such a form as to be outside the definition of ‘qualifying corporate bond’ under TCGA 1992, s. 117 then under s. 135 of the act, a gain on shares should be deferred, with the loan paper taking the place and base cost of the sold shares. This should allow an unbroken period for taper relief, from the acquisition of the shares until the disposal of the loan paper. There are, however, two serious flaws in his suggestion, which are pointed out to Mike:
- Under TCGA 1992, s. 137 ‘paper for paper’ rollover will only apply where ‘paper’ is issued for bona fide commercial reasons and not for gains tax avoidance (e.g., where a vendor has ‘paper’ foisted on him because the purchaser won’t pay full cash). Here the purchaser has made an offer in full immediate cash; it is only Mike who is talking loan notes, and for one reason only – he wants some taper relief!
- Mike’s idea of extending the taper period by loan paper, is fatally flawed by the fact that the purchaser is an individual! The ‘paper’ exchange rule of TCGA 1992, s. 135 only applies in the case of a corporate purchaser). The purchaser in Mike’s case has no intention of forming a new company except where it is the goodwill of Baldwin Ltd. which is to be bought. He certainly will not go through the corporate contortions of forming a parent company to hold Baldwin’s shares merely to provide a vehicle for the issue of loan notes to Mike.
It now seems clear to Mike that there can be no taper relief if the transaction takes the form of a sale of the shares so the possibility of the asset sale is considered and compared.
A straight sale of shares would give £500,000 immediate cash, plus the further £250,000 (tax free loan repayment). Mike’s only tax liability would be £200,000 (40 per cent gains tax) in respect of the £499,998 gain, leaving him £550,000 net of tax. The goodwill sale on the other hand, would give a chargeable gain in the company of £300,000, attracting marginal rate corporation tax of £98,250. The company’s net proceeds of £651,750 could be paid out to Mike as £250,000 loan repayment (tax free) and £401,750 dividend, on which he would pay £100,437 income tax, leaving him £551,313 net. The tiny advantage of £1,313 falls far short of any legal costs or ‘sweeteners’ involved in transferring employees.
Clutching at straws
Disappointed, Mike clutches at another straw. He asks if the position on a goodwill sale could be improved by not paying a dividend out of the proceeds, but instead leaving the £401,750 on deposit in Baldwin Ltd. for a few years, thus garnering at least some taper relief on an ultimate liquidation of the company. It is explained that any period during which Baldwin Ltd. merely ‘sits on its cash box’ will not count for taper relief (,, TCGA 1992 Sch. A1, para 11A). Consequently, a capital distribution on liquidation would be a disaster – whether this was immediately after the goodwill sale or later, – the effect would be the same i.e., 40 per cent tax on a full un-tapered gain equivalent to the liquidation distribution (less £2).
It is decided to stick with a share sale, but to seek ways to improve the £550,000 net.
A tax saving of £30,000 could be achieved on a sale of the shares if the company’s retained profits were distributed by a pre-sale dividend. This would reduce the sale price of the shares and displace £200,000 of chargeable gain (taxable at 40 per cent) with £200,000 dividend (taxable at 25 per cent), leaving Mike with £580,000 net. Unfortunately, having been bled white by Mike, Baldwin Ltd. does not have enough cash to pay a dividend of £200,000 or anything like it. Mike can’t lend the company cash as the £200,000 he drew against his loan account and his trading stock proceeds are spent or locked into investments. The company’s bank refuses to increase the overdraft by £200,000 just to pay a dividend, and the purchaser (prudently) won’t put money into the company until he has acquired the shares.
Mike resigns himself to a sale of his shares in Baldwin Ltd. (bloated with profits) and his ‘bottom line’ of £550,000. However, at the eleventh hour he is advised that simply issuing a few further shares should allow him to exit with nearly £650,000.
The solution is a pre-sale stock dividend. This technique is clearly explained by a worked example in the Inland Revenue’s Capital Gains Tax Manual, para. 58763. In Mike’s case it would work as follows:
Baldwin Ltd. could offer a cash dividend of £500 per share (a modest dividend of only £1,000 being within the company’s capability) accompanied by an alternative scrip offer of ordinary £1 shares at five hundred for one. If Mike declines the cash dividend and chooses the scrip then the one thousand further shares issued to him will represent 99.8 per cent (1000/1002) of the company’s value and would fetch £499,000 on the sale, the two original shares going for £1,000. The base cost of the stock dividend shares would be their market value on issue (i.e. the £499,000 they are sold for), leaving the only chargeable gain as £998 on the two original shares and only £400 capital gains tax payable. However, there would be an income tax liability on the issue of the new shares, payable at 25 per cent of their value (i.e. £124,750). So, with total tax of £125,150, share proceeds of £500,000, and £250,000 loan repayment, Mike exits with £624,850.
The relevant stock dividend legislation is to be found in ICTA 1988, s. 249 and 251and CGTA 1992 s. 142.
Mike’s disposal of Baldwin Ltd was a sale too soon. Had the company been sold after its first ‘birthday’, Mike would have secured 50 per cent BATR and a net outcome of £650,000. He nearly made that figure (just short by about £25,000) and he certainly did a lot better than the only alternative of £550,000 – thanks to the damage limitation provided by the stock dividend.
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February 2003 by