Deferred consideration & Entrepreneur's relief

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Deferred consideration & Entrepreneur's relief

Deferred consideration is common in business sales. Buyers use cash and or shares to defer payment often linked to business performance post acquisition. We solve problems relating to both the commercial and taxation implications in particular the risk of loss of Entrepreneurs Relief. 

Our services relating to the use of deferred consideration in business sales includes:

Deferred consideration – the risks

Transactions for the sale of shares often include earn out elements.  The deferred consideration can take the form of cash, shares or loans.  These allow the purchaser to delay payment until profits are actually achieved. Generally deferred consideration is great for the purchaser, but creates risk for the seller, who may never see the money. After all, the purchaser may not be a particularly competent manager.

Break down of the risks

The risks for a seller usually break down into:

  • The risk of increased taxation; and or
  • Commercial risks.

We have explained below the risks in greater detail.

Taxation of deferred consideration

One of the biggest risks with deferred consideration is the potential for a higher capital gains tax liability payable by the selling shareholders. The 10% entrepreneurs’ relief rate on capital gains applies on a disposal of shares or securities by an individual where, during the 12 months ending on the date of disposal, the seller:

  • Holds 5% or more of the ordinary voting share capital of a trading company or holding company of a trading group; and
  • Is an officer or employee of the company.

Cumulative life-time capital gains qualifying for entrepreneurs’ relief are capped at £10m.

Losing the ability to qualify for Entrepreneurs Relief

Unfortunately, deferred consideration may not qualify for Entrepreneurs Relief. The seller may not satisfy the above conditions, perhaps because:

  • He is no longer employed when the deferred consideration is paid;
  • His shareholding has dropped below the 5% requirement.

Similar rules apply on the disposal of interests in a partnership or limited liability partnership. Here the position maybe simpler, as the 5% shareholding requirement does not apply to partnerships.

Preserving entrepreneurs’ relief

Advance planning may avoid the problem of losing entrepreneurs’ relief.   In some cases, the seller could pay capital gains tax based on the whole value of the transaction and claim 10% Entrepreneurs relief for the tax year of completion. The point from a tax perspective is that as at the time the shares are sold the seller is still employed in the business.

The downside is, the taxable amount is calculated on the full deal value, even though the buyer has not yet paid the earn-out element.

If entrepreneurs’ relief is not available any deferred consideration paid to the seller by the buyer will be assessed to capital gain tax at the normal rate of 20% for higher rate tax payers or 18% for lower rate tax payers.

Estimating the earn out element where entrepreneurs’ relief is claimed on the earn out

We work with shareholders to calculate the amount of capital gains tax that should be paid for the tax year of completion to secure entrepreneurs’ relief.  The earn-out element may not be precisely ascertainable and provide work around solutions for tax payers. We also deal with the tax reporting required to HMRC.

The timing of when capital gains tax is payable is a factor.  We will look to see if we can negotiate a deal which means that the deferred consideration will have been paid by the time the capital gains tax is payable.  If that is possible there is more certainty for the tax payer.

Refunds of capital gains tax

Because the earn-out may not be paid or may not be capable of precise quantification there are cases where a refund of capital gains tax arises.  HMRC will process refunds in many cases and another area of our expertise is in dealing with refunds to secure repayment.

Commercial considerations with deferred consideration

Our experience indicates that the seller will be in a stronger position if the commercial implications are considered and planned from the start of a transaction.  For that reason we do recommend heads of terms are agreed.

Common commercial actions required when dealing with deferred consideration

The areas we discuss and negotiate include:

  • Putting yourself in the best position to secure the earn-out – the degree of management the seller retains post acquisition is important.
  • Being very precise about the earn-out conditions – the targets to be satisfied to receive the deferred consideration due on an earn-out need to be clear.  We will look to draft the targets carefully and use easily identifiable measures to avoid ambiguity.   We will think about what could go wrong and draft to address the risks.
  • The percentage of consideration paid on completion compared with the percentage of deferred consideration – where we are acting for the seller we will push for a greater percentage to be paid on completion as that will help to de-risk.   In cases where the buyers and sellers are connected, for example under a management buy out the need to de-risk may not be so great.
  • Share deals – where any element of the consideration includes shares additional protections and due diligence is needed as of course shares are more risky than cash.  We take you through the due diligence required as if you where buying a business as you are investing into another business if you accept shares.
  • Protecting employment status to preserve entrepreneurs’ relief for future payments – this can work if shares are sold in tranches.
  • Limiting the number of shareholders subject to earn out – if there are employee shareholders acquiring shares under employee share schemes for example it may be possible to exclude them from the earn out.
  • Impact on warranties and indemnities – if there are caps placed on liability for the sellers under the warranties and indemnities the extent of the cap needs to be linked to the risk an earn-out will not be achieved.

If you are involved in a business sale please do get in touch with us.  The chances are we will be able to add value for you.