Selling a business – a new angle
If you sell your business the buyer might offer you loan notes as payment. These can be tax efficient despite the restrictions introduced in 2010. Better still, recent changes could mean even greater savings. What’s involved?
The loan note option
When a company buys another business one of the ways it can reduce, or at least spread, the cost is to pay the seller wholly or partly in loan notes. Essentially these are IOUs, which usually come with restrictions on when you can cash them in. The advantage to you, as the seller, was that you didn’t have to pay capital gains tax (CGT) on the proceeds until you redeemed the loan notes. However, that changed in 2010.
Pay less CGT now, or more later
The 2010 change forced sellers to decide between a low CGT rate (10%), which applies when you sell a business that qualifies for entrepreneurs’ relief (ER), or delaying payment of CGT until you redeem the loan notes. You could no longer benefit from both tax breaks.
Example. Jack sold his business to Acom Ltd for £1 million on which he made a capital gain of £250,000. The whole gain qualifies for ER. Jack received £500,000 of the proceeds as loan notes, meaning that £125,000 of the gain was rolled into them. Jack can elect (by 31 January following the end of the tax year he sold his business) to pay CGT on the whole £250,000 gain at the ER rate of 10% or defer the tax on the gain sheltered in the loan notes until he redeems them. Until April 2016 that would have meant paying CGT at up to 28%.
Pros and cons
At first sight it might look like a no-brainer; surely the lower tax rate is a better option for Jack? In fact, it’s not that simple. If he takes loan notes and redeems them over several years he can set his CGT annual exemption, assuming he hasn’t used it, against the resulting capital gain.
Example. Jack redeems his loan notes in Acom over five years, releasing a gain of just over £25,000 each time. His annual CGT exemption of say, £11,000, is deducted from that. Because Jack is a higher rate taxpayer the balance is taxed at the highest CGT rate, 28%, resulting in a CGT bill of £3,920 per year ((£25,000 – £11,000) x 28%). That’s £19,600 over the five years, which is an average CGT rate of 15.68% (£19,600/£125,000); a higher rate than Jack would have paid had he not elected to defer the tax on the loan notes, but of course, he benefited by delaying payment.
Not a clear cut advantage
If Jack had crunched the numbers before deciding whether or not to defer tax he might have been unsure about which option to take. However, if he sold his business after 5 April 2015 and received loan notes the decision might now be a lot easier. Tip. When deciding on ER or deferring tax you now need only factor in CGT at a maximum of 18% because of the revised CGT rates which apply for 2016/17 onwards. More often this can tilt the balance in favour of deferring the tax. In Jack’s case it would have reduced his CGT rate to 10%, the same as with ER, but with the advantage of deferred tax. Plus, if Jack was married he could transfer some of the loan notes to his spouse before redeeming them, which could reduce the rate to just 2% (see The next step ).
The capital gains tax (CGT) on the sale of your business can be deferred by taking the proceeds as loan notes, but you’ll lose entrepreneurs’ relief (ER). However, it’s now possible for you to take advantage of lower CGT rates when you redeem loan notes so that the deferred tax is actually less than if ER applies.
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