I am advising the sole shareholder of a holding company (Holdco) that is selling its only trading subsidiary (Subco), which it has owned for the past five years. The consideration will be a fixed amount plus a cash earn-out based on Subco’s profits, payable at the end of a two-year period. Holdco will then be liquidated and the proceeds distributed to the shareholder. We understand that Holdco may be able to claim substantial shareholding exemption (SSE), but are uncertain how this would interact with the earn-out arrangement. Please can you provide some guidance on this, highlighting any tax risks for both Holdco and the shareholder?
The tax implications of the proposed sale must be considered both at a corporate and a shareholder level. The tax treatment of the earn-out must be thought through, as this will have a bearing on the outcome post-sale.
The substantial shareholding exemption (SSE)
A number of conditions must be met in order to claim SSE. In particular, we need to look at the availability of this relief for Holdco, as it is selling its only subsidiary.
The key condition here is that the claimant, Holdco, must be a trading company or a member of a trading group throughout a 12-month period beginning no more than two years prior to the disposal and ending immediately after the disposal (TCGA 1992 Sch 7AC para 18).
Holdco does not trade in its own right but will be a member of a trading group if Subco’s activities do not include, to a substantial extent, activities other than trading activities (s 165A(3)). It is assumed for this response that Subco is a trading company for SSE and entrepreneurs’ relief (ER) purposes.
Clearly, Newco will not be a trading company or the member of a trading group once the trading subsidiary has been sold. However, under TCGA 1992 Sch 7AC para 3(3), SSE will still be available if the only reason Holdco does not qualify for SSE is that it does not meet the trading criteria after the sale of its only trading subsidiary, as long as Holdco is being wound up or the winding up or dissolution ‘takes place as soon as is reasonably practicable in the circumstances’.
There is no guidance as to how HMRC interprets ‘as soon as is reasonably practicable’. In this instance, it may only be practicable to complete the liquidation of Holdco once the earn-out period has finished. The liquidation process could begin once Subco has been sold, but the final winding up of Holdco could be delayed until all the proceeds from the sale have been received.
Alternatively, if the terms of the earn-out agreement allow, the liquidator could distribute the earn-out rights to the shareholders, allowing Holdco to be wound up immediately. This may provide more certainty in relation to the SSE position and avoid the need and additional costs of retaining Holdco.
Assuming that all the other SSE requirements are met, Holdco should therefore be able to claim the relief on disposal of Subco.
The earn-out
The earn-out right is based on the future profitability of Subco and as such is unascertainable at the date of disposal. According to the principles laid down in Marren v Ingles [1980] STC 500, the right constitutes a separate asset (a chose in action) which must be valued and forms part of the disposal consideration which is subject to SSE.
If the final earn-out exceeds the value of the chose in action, this additional gain would not be eligible for SSE, as the consideration derives from the earn-out right and not the original disposal of the shares. Conversely, if the earn-out consideration is lower, there is no loss relief for Holdco, but remember that the original gain is covered by SSE.
Ideally, the value of the earn-out right should be as high as possible, but the valuation cannot be determined with hindsight and should take into account the expectation of receiving further proceeds from the earn-out. HMRC may be sceptical if the value was exactly the same as the proceeds received.
If the rights are transferred to the shareholder as part of the liquidation of Holdco, any gain or loss on realisation would accrue to the shareholder.
The shareholder
Where the shareholder is continuing to work for the purchaser, it is important to check that the earn-out is not linked in any way to his continuing employment to avoid any income tax risks.
The CGT position for the shareholder will depend on whether the liquidator distributes the chose in action to the shareholder. If the shares in Holdco are sold within three years of the cessation of trade, ER would be available (TCGA 1992 s 169I(7)). This means that any payments by the liquidator to the shareholder within three years of the sale of Subco would be subject to 10% CGT.
If Holdco is liquidated immediately after the share sale and the upfront cash plus the earn-out right are distributed to the shareholder, the proceeds will qualify for ER. However, any amounts received which exceed the value of the earn-out will be taxed at 28%, as ER would only apply to the original disposal of shares and not to any gain on the disposal of a chose in action. Any loss on the realisation of the chose in action can only be carried forward. It cannot be used to reduce the gain arising on the liquidation of Holdco.
To summarise
Overall, there may be some merit in retaining any earn-out rights within the company until paid, assuming there are no adverse issues with SSE.
Any additional earn-out payments would then be chargeable at 20%, rather than 28%.
If less is received from the earn-out, there is no impact on the company but a lower amount is distributed, so less tax is suffered by the shareholder.
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