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Tolley's Practical Tax by Richard Pincher

Richard Pincher considers the current tax issues regarding Management Buyouts (MBOs).What points should an accountant bear in mind when approached by a management team proposing to acquire the business for which they work (an MBO)? This article will look at the general tax issues that the general practitioner should consider.

Terminology

It is useful first to clarify some terminology. We have a ‘Business’ that the ‘Management’ wishes to acquire, often referred to as the ‘Target’. They will use a new company for the acquisition (the ‘Vehicle’). Others (the ‘Investors’) may provide the Management or the Vehicle with funds. That Business may be owned by private individuals (‘Owners’) or by a ‘Company’, itself owned by ‘Shareholders’.

Assets or shares

The first big question is whether to acquire the assets of the Business or, where relevant, the shares in the Company. If the Company operates other businesses, then the Company may transfer the assets that make up the Target Business to a ‘Successor Company’ before selling the shares in the Successor Company (a ‘hive down’).

Shares

Some of the circumstances that favour the purchase of shares are:
The transfer is relatively simple because all the business transfers with the ownership of shares. However, the Company might not own the assets that it appears to own. Therefore, a careful investigation of its assets is important. In addition, the contract for the transfer of shares can be complex, not least because of the provisions dealing with tax.

• The Seller probably benefits from more favourable capital gains tax and general tax planning opportunities. This article will not go into the details of vendor tax planning.

• The stamp duty on shares is lower than the stamp duty on certain assets, which might produce a saving.

If the Company made profits before the MBO but makes losses in its first year after the MBO, it may be able to set those losses against those profits (under ICTA 1988 s 393A subject to ICTA 1988 s 768A).

On the other hand:

• the purchaser receives no immediate tax relief for the costs of acquisition;

• the Company comes warts and all, that is to say that buyer must bear the consequence of any liabilities. This means that due diligence into the potential liabilities has to be comprehensive and expensive or based on a judgment not to investigate all potential risks.

Assets

If the purchaser buys the assets of the Target Business, then the seller may be taxed:

• On the cessation of that trade, this may not be favourable. It will include possible charges on stock and work in progress and balancing charges where capital allowances have been claimed.

• On extracting the cash from the Company when the Shareholders may also suffer a perceived double tax charge.

However, the Company may have brought forward losses that can reduce these tax charges. On the other hand, if the Target Business contains significant intellectual property assets, the deductions available for the costs will produce a significant benefit to the buyer. In a similar vein, the buyer will need to consider the effects of any negative goodwill, that is to say any excess in the price over the fair value of the assets (under FA 2002Sch 19(16)).

Hive down

The tax success of a hive down depends on the application of ICTA 1988 s 343. This section provides that the trade is treated as continuing and the Successor inherits the tax affairs of the Company in relation to capital allowances and carried forward trading losses. The losses may be restricted (under ICTA 1988 s 343(4)).

To secure the application of s 343, the Company must beneficially own the Successor when the hive down happens. The deal with the buyers will need to be carefully structured so that the Company does not lose beneficial ownership of the Successor but is not obliged to make the hive down until the Buyer is obliged to pay. The parties should plan for an intervening period between the hive down and the share sale. In that period, the Successor should take reasonable steps to demonstrate that it has taken over the Business. For example, it can change its bank accounts and notify its employees. If that is not possible, the parties should take further legal advice.

The parties may also be concerned to bring the hive down within the stamp duty relieving provisions for intragroup transfers of assets (FA 1930 s 42 and FA 2003 Sch 7). To do so the
Company must make the transfer before there are any arrangements for the Successor to leave the Company’s group. That makes the timing of the hive down relative to the progress of negotiations critical.

Special provisions apply to reverse the benefit of the intragroup transfer relief in relation to land transferred within three years of the hive-down.

Finally, the parties may also be concerned to secure the benefits of the capital gains tax relief for intragroup transfers (TCGA 1992 s 171). This relief deems the group members to have made any such transfers at a price triggering no gain or loss. This means that the transfer triggers no gain in the hands of the Company.

However, the gain that would have occurred crystalises when the Successor leaves the Company’s group within six years of the transfer of assets (TCGA 1992 s 179). In the first instance, this charge would fall on the Successor.

However, the parties can agree that the charge will accrue to another member of the Company’s group. This crystalisation charge can apply not only to the assets clearly included in the assets register of the Company but also to certain items of goodwill, in particular that related to intellectual property.

Company Funding

The sheer effort of raising finance can leave no energy for considering the tax consequences of the funding structure that the Management might adopt. However, that structure will have tax consequences.

Funding can be injected at several levels that are conflated here for brevity. Unless interest is paid to a qualifying institution (ICTA 1988 s 349B), it must be paid net. A private equity house will probably not qualify for gross interest payments.

Loan relationships

The loan relationship rules (FA 1996 and FA 2004 s 52) are the most relevant from a tax point of view when they operate to prevent tax relief for interest under relationships entered with a view to obtaining a tax advantage. When corporate parties to the loan relationship are connected, as is likely in the circumstances of an MBO, the loan must be accounted for on the accruals basis. The tax then, broadly, follows the accounts.

However, no accrual is allowed for interest charges: paid after the accounting period in which they accrue, to a lender that is not subject to corporation tax or, where the borrower and the lender are connected. In those circumstances, a deduction is only available for interest that has been paid.

Stranded interest

A quirk of the loan relationship rules is that they can produce interest that qualifies for no tax relief – referred to as stranded interest. Typically, in its first years of operation the Vehicle does not generate taxable profits in excess of its financing costs.

Furthermore, any taxable profits are reduced by brought forward losses before they are set against any financing cost.

Given that the Vehicle incurred the finance to acquire the Business and that was not a trading purpose, the excess charge can only be carried forward and set against future non-trading profits.
The Vehicle may never have such profits – thus the term stranded interest.

Alternative finance

Alternatively, discounted loan notes may get round the issue of stranded interest. However, the discounted security rules would have to be considered (FA 1996 Sch 13(3)).

If the Company forecasts no taxable profits in the first couple of years of operation, the lack of relief for interest may make equipment leasing a more favourable financial option. When considering the funding structure, the parties should also have in mind the: financial assistance rules and the close company loan regime. The former is beyond the scope of this article.

Management borrowing

The close company loan regime would be relevant if the Management intend to use the Company’s assets to fund, by way of loan, their acquisition (ICTA 1988 s 419). Unless they fell within one of the exemptions (ICTA 1988 s 420) 25 percent of the amount of the loan would be due to HMRC nine months after the accounting period in which the loan was made. That payment to HMRC would be repaid when the loan was repaid. Tax would also be due on any benefit arising from a low interest rate charged by the Company.

The Management team will receive no tax relief for interest paid on an overdraft used to fund the acquisition (ICTA 1988 s 363). However, normally the concern is to obtain interest relief for other types of third party loans (ICTA 1988 s 832). The Management can use the funds that they raise to buy shares or make a loan to the company. If they withdraw funds from the company, then the relief will be scaled back. (The Management, like all the Investors, has to choose between relief for interest and the Enterprise Investment Scheme benefits. They cannot have both.)

To qualify for interest relief, the company must be close (which depends on how many people control the company) when the Management buys the shares (ICTA 1988 s 13A(2)). The precise definition of a close company requires detailed consideration beyond the scope of this article.

Nevertheless, the future rights of investors are relevant and should not be overlooked particularly as in these circumstances being close may be beneficial.

The company must also exist wholly or mainly: to carry on commercial trades, to hold land to lease to unconnected bodies or to act as a holding company for such companies. For a manager to qualify for the relief, they must either: control 5% of the ordinary shares of the company or satisfy the employment test. To satisfy the employment test, the manager must work for greater part of their time, in the period between raising the loan and paying interest, in the management or conduct of the company or its associates.

Normally, the Vehicle will not be operational when the managers make their investment. If they work full-time in the business, they will, usually, qualify for the relief if the business starts no more than halfway through the interest period. If commencement of the activities is delayed, extending the first interest period might secure the tax relief.

Furthermore, the institutions will probably inject their funds, (with the result that the Vehicle is no longer close) before the business starts to trade under its new owner. Without more conditions being met that would mean that the Management would not qualify for interest relief.

However, Statement of Practice SP3/78 confirms that relief will continue to be available, in these circumstances, (provided that all the other conditions are satisfied). The High Court has confirmed that the company qualifies if it was established to carry on a business despite not yet having commenced the business (Lord v Tustain; Lord v Chapple 65TC 761).

Relief is also available for borrowings to acquire an interest in an employee controlled company (ICTA 1988 s 361). This seldom arises in practice because of the condition that employees control the company. Satisfaction of that condition is difficult to secure for the future. However, the possibility should not be overlooked.

Relief for costs

The costs of creating new companies and obtaining equity funding will not be tax deductible.

The costs of raising loan finance will be deductible on an accruals basis, under the loan relationship rules already described. Professional fees will have to be considered on a case-by-case basis. Broadly, investment appraisals and investigations are deductible as revenue.
However, costs incurred once the decision to invest has been made do not qualify as revenue expenses.

Management shares

The issue of shares in connection with employment is taxed under the provisions introduced by FA 2003 that is interpreted for the purpose of MBO’s under a Memorandum of Understanding with the British Venture Capital Association. The new rules have extended the definition of the securities. It includes shares, warrants to subscribe for securities, units in collective investment schemes, futures, debt instruments and contracts for differences (ITEPA 2003 s 421B and ITEPA 2003 Ch 2 Pt 7).

More importantly, the Management is unlikely to succeed with the argument that they acquired the shares as investors and not employees – the device previously used to avoid a tax charge.

Management shares are likely to fall within the remit of the new rules because they are of a separate class to those issued to other Investors. The shares are subject to the new regime if
they are subject to certain restrictions that reduce the value of the share. Preemption rights (allowing other shareholders to acquire the shares of a departing shareholder) will probably make the shares subject to the regime. The exemption for those who leave because of their misconduct is clearly very narrow. In certain circumstances, if the restrictions on a share fall away within five years, it does not count as a restricted share.
The tax charge on the grant of restricted securities is not immediate. It arises in three circumstances, broadly: when the restriction ceases, or varies or the securities are sold subject to the restriction.

The charge aims at taxing the unrestricted market value of the security. The managers can elect to vary the standard operation of the charge. The effect is to trigger a current tax charge on the current value of the restriction on the shares. In some cases, the lower value will justify the immediate tax charge.

The agreed memorandum creates a so-called safe harbour situation to prevent any tax charge, which merits study. However, it is based on a conservative reading of rules. On the other hand, the agreed memorandum provides helpful guidance on ratchets. This means that ratchets generally fall into one of two categories. That is to say, if the performance hurdle is not met, either the Management’s shares reduce or the other Investors have the right to subscribe for more shares at nominal value.

The new rules also introduce a reporting requirement. The Form 42 must be sent in by 6 July following tax year in which a chargeable event takes place. If the Management is given shares in the Vehicle and another company controls it, then the shares will qualify as readily convertible and so subject to PAYE and NIC. As a controlled subsidiary, the Vehicle will also not be able to create an Enterprise Management Incentive share scheme.

Contract

Tax should be a zero net adjustment on the commercial value of the transaction. This means flushing out the presale tax liabilities and adjusting for them. When there is a clear and present, liability that should be a pound for pound adjustment to the price.

Sometimes the Seller will try to apply the limitations under the general contract to the tax liability. That is a matter for the parties to agree. Future and uncertain liabilities should also be considered but it will probably not be appropriate to adjust the price.

Therefore, the contract needs to reflect the liability, probably giving the Buyer or the Vehicle the right to recover the liability from the Seller if and when it arises. That often requires careful drafting. And, of course, a written contract is only as good as the Seller’s bank account

Briefly, the reciprocal may also exist, that is to say that the Vendors may demand value for tax reliefs that might be of value after the sale that arose before the sale.

Heads of terms

Dealing with outline tax issues in the heads of terms is sensible. For example, who will give the indemnity and which warranties, what limits will apply to the warranties and will they apply to the indemnity.

Warranties

Warranties are statements of fact about the Business giving the Buyer the right to damages if they are wrong. Whether the Vendors should give the Management warranties is a moot point. The issue from the Vendors’ point of view is that the Management often has better knowledge of the Business. However, this may not extend to the tax affairs of the Business, unless the Management have also been involved in that aspect of their Business.

In any case, however, other Investors will not want to take the tax risk or, indeed, to see it transferred to the continuing Management. The investigating accountant’s report should be translated into the terms of the warranties. However, usually the lawyer’s standard form will cover most of the detail.

Indemnity/Covenant

The indemnities identify risks against which, usually, the Vendor will keep the Buyer, or the Target, financially secure. Sometimes the indemnities are in the form of a covenant – a document under seal.

September 2005

RICHARD PINCHER
Solicitor

This article was originally published in Tolley’s Practical Tax, LexisNexis Butterworths leading information service for small to medium sized tax and accountancy practices. It provides the day-to-day information needed to deal with all tax compliance issues and general client problems. For more information or to order this title please visit www.lexisnexis.co.uk/taxationweb