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Tax Bite – Loan Notes in Share Sales

Tax Bite – Loan Notes in Share Sales

In this Tax Bite, we briefly summarise the use of loan notes from an individual seller’s tax perspective in share sale transactions.

Deferral of CGT (or not, if the seller prefers)

Normally, if part of the consideration for a share sale is satisfied in loan notes issued by the buyer entity, the seller does not trigger capital gains tax on the gain attributable to the loan note element of the consideration.

This deferral is subject to meeting the statutory conditions for a rollover, which include the recently-revised anti avoidance provisions, i.e. rollover treatment is not available if the main purpose or one of the main purposes of the arrangement is to reduce or avoid liability to capital gains tax (or corporation tax). The HMRC clearance (which is usually sought) relates to this purpose condition only. Taking advantage of the tax deferral afforded by rollover treatment is not, of itself, considered “reducing or avoiding” CGT for those purposes.

So, loan notes can generally defer the CGT point until the loan notes are redeemed. And if structured correctly (see below), CGT is only ever paid on the actual value received on sale/redemption of proceeds.

Two other common situations where loan notes are used for tax deferral purposes by sellers are: -

• Earn outs: for a cash earn out, a CGT liability is crystallised on the initial sale of the shares based on the value of the right to earn out (i.e. an estimate of what the earn out will deliver), often referred to as Marren v Ingles treatment, with a further gain or loss when the earn out pays out. However if the earn out can only be satisfied in loan notes (or indeed shares) in the buyer, there is normally no up-front gain triggered on the earn out, and instead all of the CGT on the earn out is triggered when the loan notes (issued in satisfaction of the earn out consideration) are redeemed. This generally means the loan notes defer the receipt of cash by six months, as the loan notes have to exist for that long after issue in order to achieve the tax deferral.

• PE structures where sellers are to hold shares in Topco. In a typical PE deal, sellers will initially receive loan notes in the buyer (Bidco) which will then be exchanged for loan notes up the chain of companies in the buying structure by way of put and call options, eventually being exchanged (in whole or in part) for shares in the Topco. This again generally means the CGT attributable to that element of the consideration for the deal is deferred until the Topco shares are sold.

Sellers may however prefer not to defer the CGT point, even on deferred / rolled / earn out consideration, for example if they are concerned about the potential for increases in CGT rates in the future or if the initial cash consideration does not use up the sellers’ business asset disposal relief (BADR) entitlement, as generally tax deferral into loan notes will not allow for any further BADR claim on the subsequent gain. BADR concerns are however much less significant these days than they used to be – the maximum cash tax saving that can be made through BADR now is £60,000, when in the past it was as much as £1m.

If a seller is required to roll some value but does not want to defer the tax, typically the rollover is “broken” by selling for cash and reinvesting the cash in the shares or loan notes. This means the tax is triggered up-front, but of course comes with a cash flow disadvantage plus the risk of having triggered tax on value that might not ultimately be achieved if the loan notes / shares invested in go bad - that would result in a capital loss, which can’t be carried back.

There is a popular misconception that the seller needs to decide between non-QCB and QCB loan notes. That is not the case (see below - we would always use non-QCBs) but the seller does need to decide between deferring and not deferring the CGT. Different sellers can do different things, and a seller can create a partial deferral if structured correctly. If the seller decides to defer tax and then later wishes they hadn’t, there is also a facility to elect out of the roll over in certain circumstances. All of this needs to be discussed in detail with clients and there is no “one size fits all”, some are very keen to get all their tax paid up whereas others would never want to pay tax early regardless of the possibility of future tax rate rises.

Why sellers always want “non-QCB” loan notes for tax purposes

If shares are exchanged for qualifying corporate bonds (QCBs), the gain on the original shares is calculated and “frozen” at the point of exchange, then brought back into charge when the QCBs are disposed of or redeemed. But if the QCBs become worthless, the frozen gain is still eventually brought back into charge.

However, where a non-QCB is issued (as with consideration in shares), subject to meeting the rollover conditions, there is no disposal for CGT purposes at the time of the exchange. Instead, the gain is only triggered when the non-QCB loan notes / shares are disposed of. If they become worthless, this means in effect no CGT will have been triggered on that part of the consideration.

Historically there were situations where individual sellers may have preferred QCBs for tax purposes, but now they should always seek non-QCBs.

To make a loan note a non-QCB, the normal method is to include a foreign currency redemption election facility. There are some potential drafting pitfalls in this, so the wording always needs to be checked carefully.

If you have a transaction involving seller or management loan notes and would like to talk through the tax structuring and any tax choices that may be open to the client, please do get in touch.