Potential changes to capital gains tax – planning for the period to 3rd March 2021

Background

Changes were made to capital gains tax ("CGT") for individuals in the March 2020 Budget. The principal change was the ‘morphing’ of Entrepreneurs’ Relief with a lifetime ceiling per individual of ￡10M into Business Assets Disposal Relief (“BADR”) with a significantly less generous lifetime ceiling of ￡1M per individual. There was little other change to CGT other than the introduction of rules to seek to prevent individuals from benefitting from the pre-existing ￡10M ceiling through creating disposals before the rule change took effect.

In November 2020, the Office for Tax Simplification (“OTS”) published a paper on potential reform to capital gains tax, making several points including whether CGT should be linked to income tax rates amongst other possible changes.

The Quandary

For individuals looking to sell a business, there is a natural fear that the tax burden on sale will increase substantially (particularly if the current 10%/20% CGT rate were to move to income tax rates) and what steps can be taken to try to 'bank' the current CGT environment (upon the basis that things almost certainly will not get better and could get significantly worse).

A Political Analysis

The impact of covid-19 on the economy has been immense and will need to be paid for. It will not be funded exclusively by capital taxation in either the short or the long-term. Capital taxation (including CGT) is not the means by which the hole created by covid-related government spending during 2020 (and potentially beyond) will be filled. The economic impact of covid-19 will be a multi-generational matter. It will of course impact on tax policy, however, this will be a long-term issue.

The issue facing the Chancellor within the context of CGT is should he execute a 'hike' for a relatively small revenue gain?

One view is that current circumstances allow probably a lifetime opportunity to make a variety of changes, including changes to CGT, Inheritance Tax ("IHT") (together with other seemingly small changes) that have been estimated as raising between ￡20Bn and ￡50Bn per annum. From a voting perspective, such a course of action is likely to be immaterial. It seems improbable that revenue raising measures relating to CGT or IHT would changes voting behaviours leftwards. If they did, that the effect of that swing would be material to a voting outturn. Further, the next election would seem likely to be some time off and voters based upon past events generally have had short memories.

From an internal Conservative party perspective, however, changes to CGT might not be popular on the backbenches. We have already seen how the Conservative backbenches have railed against the economic consequences of restrictions on business operations and civil liberties under the covid-19 restrictions. It is suggested that anything that might be viewed as a CGT hike (and other tax rises) would not be viewed positively from a Conservative backbench perspective.This leaves us with the current dilemma as to where the land lies.

Whatever the future holds, it is conisdered reasonable to believe that the tax burden will not become more benign anytime soon in most areas of taxation. Changes to CGT are not a given, however, for the reasons set out above, it is understandable that consideration is rightly given now as to how one deals with such changes, if they eventualise.

Anti-forestalling

Governments (of all persuasions) are creatures of habit, or rather, the Parliamentary draftsmen who are responsible for drafting the legislation that aims to ensure that the Government’s policy intents are achieved, are creatures of habit. This is evidenced through recycling of concepts that have been used previously in drafting techniques.

The term ‘anti-forestalling’ in the current context is used for rules introduced that seek to prevent taxpayers from gaining an advantage through taking essentially artificial action before a change in legislation 'banking' the pre-existing rules.

The changes to CGT in March 2020 had been pre-announced in conceptual terms by the Conservative Party manifesto for the December 2019 election. Upon the basis that this pre-warning had been given, the legislative changes announced in March 2020 included anti-forestalling provisions with the aim of frustrating those who sought to artificially avoid the changes introduced, of which forewarning had been given.

It is suggested that the publication by the OTS in November 2020 are grounds upon which one can expect, if adverse changes are made to CGT, that similar anti-forestalling measures will be included in the 2021 Budget. The likelihood of such provisions should be borne in mind therefore in the run up to the March 2021 budget.

The anti-forestalling provisions introduced in 2020 which may be replicated should adverse CGT changes take place in March 2021 are as follows:

• Normally, the date of disposal for CGT purposes is the date on which unconditional contracts for sale are entered into, however, for such contracts that straddled Budget day 2020 i.e. that exchange took place before and completion was to take place after, the disposal date would be the date of completion, unless the parties were not connected, that obtaining a tax benefit was an advantage being sought and that a claim is made to that effect. Alternatively, if the parties were connected, the transaction was entered into for wholly commercial purposes and did not include obtaining a tax advantage.
• It is common in transactions relating to the sale of shares in companies, for the sale consideration to include the issue of shares and securities to the selling shareholders. Typically, such a transaction will benefit from paper for paper relief i.e. the gain that would be attributable to the shares or securities does not immediately crystallise but rather arises on the eventual sale/redemption of those shares or securities. It is possible, by election to disapply that rollover of the gain so that the gain is immediately crystallised on the sale consideration, regardless of the form it takes. Crucially, such an election can only be made where the resulting gain is eligible for BADR at least in part. The anti-forestalling rules for 2020 provides that the election shall be treated in certain circumstances as when made, not when the disposal took place, specifically where the company in question remains the individual’s personal company. This would mean that the making of such an election after an adverse change in rules would secure no benefit.

Where does this leave us?

One form of planning that was undertaken in the run up to March 2020, that was circumvented by the provisions relating to transactions straddling budget day, related to contracts typically with a trust that the vendor created for his own benefit (and similar reltated party transactions) where contracts were entered into but not completed. But for the anti-forestalling rules, this would have created a disposal before Budget Day under the old rules, with then the possibility of parties setting the contact aside by mutual rescission before the contract was completed, if it was decided not to proceed with the “disposal”. The anti-forestalling rules blocked the sought tax advantage of this type of planning. One could look to replicate this planning in the run up to 3rd March 2021, however, there is the very real risk that if there are CGT changes, nothing will have been gained due to anti-forestalling measures and at best therefore, costs will have been incurred for no benefit.

If there were not to be equivalent anti-forestalling rules to those introduced for the 2020 changes, there remains other lines of attack including the General Anti Abuse Rule for steps taken without commercial substance.

It is suggested that non-commercial attempts to 'bank' the current system should not be undertaken, or if they are undertaken, are done so in the knowledge that the system is 'wise' to such approaches. As such planning has been defeated before by anti-foresalling measures it would seem odd if such measures would not be deployed again if CGT rates are raised.

This leaves us with the possibility of accelerating commercial deals and then seeking to ensure that these are structured to 'bank' the current rules.

The issue that one will encounter is that it is very rare for the sale of shares in a private trading company to be entirely for cash consideration: consideration is frequently paid in shares issued by the acquiring company or in profit related ‘earn-out’ rights. From the anti-forestalling rules set out above, it will be seen that the approach has been to seek to attack artificial tax avoidance arrangements but also to hit what might have been entirely commercially driven transactions where consideration fell to be paid after the March 2020 change in rules. If one assumes that CGT rules are to be changed adversely and anti-forestalling arrangements are introduced, this begs the question as to how to structure share sales in the run up to 3rd March to reduce the risk of being caught by anti-forestalling rules?

Non-share based deferred consideration/earn outs

Such payments take a variety of forms, depending upon the nature of the deal. In the analysis below, it is assumed that the transaction is commercial and between parties at arm’s length. Broadly, the characterisation can be broken down into the following classes:

• Simple deferred consideration – this is a defined amount will be paid at a defined point after the sale has gone through. This is treated as cash consideration for CGT purposes, however, with the provision that if it proves irrecoverable, there is the capacity to recompute the gain disregarding the unpaid consideration. Where there are contracts entered into prior to 3rd March 2021, the existence of such consideration would appear not to be problematic based upon anti-forestalling rules that have been implemented previously.
• Contingent deferred consideration – this is a defined amount that will be paid at a defined point after the sale has gone through, contingent upon certain events having occurred e.g. the meeting of profit targets etc. As above, such an amount will be brought into account as if it were cash consideration for CGT purposes but with the capacity to recalculate the gain should the consideration not prove to be payable or paid. As above, the existence of such consideration would appear not to be problematic based upon the anti-forestalling rules that have been implemented previously. This is termed contingent ascertainable consideration.
• Unascertainable consideration – this is consideration that is payable based upon facts that are not known or ascertainable at the date of the sale and where the payment varies based upon what transpires e.g. where the quantum of a deferred payment depends on the profits generated in the period of three years post-sale. In this instance, the tax analysis is that the market value of the entitlement should be quantified at the date of sale and taxed. Any excess payment over this amount is taxed to CGT by reference to when it is received. Should the pay-out be less than that taken into account, there is an entitlement to claim a loss and carry back against the original gain. This form of deferred consideration will be problematic if one believes that rates will increase. It would be preferable to go down the route of setting consideration that is ascertainable with a warranty as to conditions in which there will be a clawback in consideration thus accelerating the gain into current rules, however, should clawback occur, there will still be the ability to relate back the loss. The question posed is do you want to accelerate the tax liability against the risk of future tax rises?
• Deferred consideration paid by securities – securities for these purposes are generally referred to as loan notes i.e. debt instruments issued by the acquiring company. These are viewed in two different forms: qualifying corporate bonds (“QCBs”) and non-qualifying corporate bonds (“non-QCBs”). To explain the difference, a QCB is the equivalent of vanilla ice-cream. A non-QCB is tutti-frutti i.e. the same ice cream but with bits added. Because of the tax characterisation of deferred consideration paid by securities, generally, non-QCBs will be used (and this becomes a matter of legal drafting). Where non-QCBs are issued, they will be viewed as securities for tax purposes and therefore any gain on the sale of shares may be rolled into the issue of these loan notes. This would appear to be potentially problematic if you are looking to bank the existing rules as the gain on redemption of the loan notes will be taxed under the rules applying when they are redeemed. It would seem sensible, if one is looking to bank the existing rules to follow non security-based consideration rules and ensure that the consideration is properly characterised as ascertainable (with any claw back being under the terms of warranties etc. as set out above). 

Share-based consideration  

As noted above, it is common for at least part of the consideration for a sale of shares by the shareholders in a target company to take the form of the issue of shares to those shareholders of new shares in the predator company.

The general rule has been that the gain on shares that have been paid for by the issue of new shares will be looked through for CGT purposes i.e. the old shares held in the target company and the new shares held in the predator company are treated as one and the same: the sale of the old shares and the acquisition of the new shares are ignored for CGT purposes.

If you have the situation where the consideration for the sale of shares in a target company is share-based, if you want to benefit from the pre-existing rules, one will have to structure the transaction so as to ensure that the paper for paper rules do not apply. This does have the disadvantage that a gain will be crystallised in the share-based consideration based upon the value at the transaction date, regardless of the future value of those shares, with no capacity to carry back any loss. For the reasons set out above, one should not assume that disapplication of the paper for paper rules, by election will be a possibility.

Structuring a share sale from a non-paper for paper viewpoint should be relatively easy, provided that the commercial objectives of the parties can be met. Generally, the objectives of the purchaser in offering shares rather than cash are at least two-fold: liquidity and incentivisation being key i.e. the purchaser is looking to minimise the cash-burn and also to ensure that the vendors have a stake in promoting the growth of the predator.  

Methods to be adopted will include cash consideration with cross options for share subscription, agreements where the purchaser has the option of payment of cash or shares etc. This will need to be looked at on a deal by deal basis from a commercial viewpoint, however, if one is positively looking to ensure that paper for paper relief does not apply, this is achievable.

Golden rules

Structuring to produce a non-commercial gain in advance of Budget 2021 for the reasons set out above, should there be adverse changes to CGT carries with it the real risk that the actions taken will prove a waste of time and money. You might not actually lose out beyond this loss of time and costs incurred; however, it is considered that the odds are you will not gain should adverse tax changes emerge in March.

Every share sale has its own characteristics. The above sets out only general observations. Take definitive and specific advice.

Look at things commercially first and then try to wrap the tax around it. To be driven by tax rather than the commerciality may well involve missing the wood for the trees.