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Takeover tax planning: How loan notes can help

04 August 2008

With appropriate structuring of takeovers, sellers can benefit from tax savings by receiving loan notes.

Where an individual seller receives loan notes from a purchaser in exchange for shares in a company, there are various commercial benefits to be derived, including helping the purchaser finance the acquisition. However, providing the loan notes are properly structured, a seller will be able to benefit from the opportunity to defer crystallising any capital gain in respect of their shares until a subsequent tax year.

This is particularly relevant to individuals who might already have utilised their annual capital gains tax (CGT) exemption (£9,600 for 2008/09) for the year of sale, and who would thus prefer to crystallise any gain in a later year, when the full annual exemption would be available to them. The obvious disadvantage is that a seller would not receive cash immediately but, where this is not a concern, loan notes may be worth considering.

Two further issues also need to be considered: the availability of entrepreneurs’ relief (which broadly subjects the first £1m of qualifying gains to tax at 10% rather than the normal 18%), and whether any deferred consideration will be received.

QCBs or non-QCBs?

Loan notes can be structured either as qualifying corporate bonds (QCBs) or non-qualifying corporate bonds (non-QCBs). Both QCBs and non-QCBs allow a seller to defer any capital gain in respect of the shares sold. However, where QCBs are used, the tax on the deferred gain becomes payable when the QCB is ultimately redeemed or disposed of, even if the QCB becomes a bad debt and no money is actually received on redemption or disposal. However, where non-QCBs are used, the gain originally deferred is reduced or eliminated if the loan note becomes a bad debt. Also, on a subsequent takeover of the purchaser company, it is possible under certain circumstances to obtain a further roll-over on the transfer of non-QCB loan notes.

What about entrepreneurs’ relief?

Entrepreneurs’ relief has now replaced taper relief for disposals by individuals after 5 April 2008. Entrepreneurs’ relief applies to the first £1m of lifetime gains made by an individual, and gives an effective tax rate of 10%.

Briefly, the relief will apply to a disposal of shares where the following conditions are satisfied for one year prior to disposal:

How is deferred consideration taxed?

Deferred consideration is usually:

If a shareholder sells shares for contingent ascertainable consideration he is taxed on the full amount of the consideration ignoring the fact that it is contingent. If the amount ultimately received is less than the amount taxed, he can obtain a tax refund for the shortfall.

A shareholder who sells shares for contingent unascertainable consideration has to value the right to future consideration and pay tax on it at the time he disposes of his shares. When the right is disposed of, a further gain or loss may arise. An election can be made to carry back any loss arising on the subsequent disposal against the previous gain.

What structures can be used and how will they be taxed?

Wholly cash consideration

The shareholder will pay tax on the full amount of the consideration. Entrepreneurs’ relief may be available on the first £1m of any gain so that this is taxed at 10%. Otherwise, the consideration will be taxed at 18%.

Cash plus deferred ascertainable consideration

As above, tax is payable on the cash element.

The choice is whether to structure the loan note as a QCB or non-QCB which will depend on whether the individual can claim entrepreneurs’ relief.

If so, it is likely that a seller will wish to receive a QCB because, for entrepreneurs’ relief to apply where loan notes are non-QCBs, the conditions for entrepreneurs’ relief have to be met both when the loan notes are acquired and when the loan notes are disposed of, which is unlikely. However, as stated above, the downside to receiving a QCB is that if a purchaser defaults, the seller is still liable to pay tax on the gain originally deferred. If no entrepreneurs’ relief is available to be claimed, the use of a non-QCB will allow the original gain to be deferred until the loan note is redeemed and will provide protection should the loan note become a bad debt.

Cash plus deferred unascertainable consideration

As above, tax is payable on the cash element.

Normally, the loan note would be structured as a non-QCB as it is unlikely that entrepreneurs’ relief would be available in these circumstances due to the conditions for entrepreneurs’ relief having to be met both when the loan notes are acquired and disposed of.

However, if a seller wants to claim entrepreneurs’ relief it may be worthwhile restructuring the earnout so that either the loan note is a QCB with a reduction in the amount payable if targets are not met, or a loan note is not used to enable a seller to value the right to the earnout on disposal and pay tax up-front. Where the period between the date of disposal and the date the earnout becomes payable is reasonably short a shareholder may be prepared to do this for an 8% saving.

The above are some of the possible options available which show that, with careful planning to suit the particular circumstances of each transaction and seller, using loan notes on a takeover can be a valuable tax planning measure.

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Tom Wilde

Solicitor
T: 08700 86 8713
I: +44 (0)118 965 8713
E: tom.wilde@shoosmiths.co.uk