Earn-outs – ‘Ascertainable’ and ‘unascertainable’ consideration
An earn-out right is legally a ‘chose in action’ i.e. broadly, a right to have something done and following the decision in Marren v Ingles  STC 500 and related appeals, such a right is regarded as an intangible asset for CGT purposes. The sums received under the earn-out are liable to CGT as capital sums derived from an asset (see TCGA 1992, s 22). However, such disposals do not fall within any of the categories of ‘qualifying business disposal’ for ER purposes (see TCGA 1992, s 169H).
Under the latter scenario in the Example, if Mary receives £75,000 on 1 June 2015 and £100,000 on 1 June 2016, she would have further gains of £75,000 (£75,000 + £100,000 - £100,000) over the two years 2015/16 and 2016/17, which do not qualify for ER.
If the earn-out right had been valued at £200,000 she would have paid CGT for 2014/15 based on total consideration of £700,000 but with the full benefit of ER. In that case she would realise losses of £25,000 (£75,000 + £100,000 - £200,000) over the two years. However, under TCGA 1992, ss 279A-279D, an election may be made, broadly, to carry back such losses to the year of sale for offset against the gain. This would enable Mary’s gain for 2014/15 to be reduced, effectively, to reflect the actual amounts actually received under the earn-out with the full benefit of ER.
Mary’s 2014/15 tax return is due for filing by 31 January 2016, and while the valuation of the earn-out right should exclude hindsight, it should by that time be possible to take a pragmatic view. If the earn-out was spread over a longer period or based upon an uncertain event, then obviously some considerable care is needed over the valuation of the right.
Deferred consideration - shares
Where part of the consideration consists of shares in the purchaser, whether ER will be due when those shares are realised will depend upon whether the vendor continues as a director or employee of the purchaser and whether the purchasing company qualifies as the individual’s ‘personal company’ (see TCGA 1992, s 169S(3)).
If the consideration shares are not expected to qualify for ER an election may be made (under s 169Q) for the share reorganisation provisions of TCGA 1992, s 127 not to apply. The effect of s 127 is basically to roll-over the part of the gain relating to the shares until they are disposed of. Making the election means that CGT is payable up-front in respect of the consideration shares, but also enables ER to be claimed on the whole consideration.
Deferred consideration – ‘QCBs’
Loan notes are a form of debenture, and unless these are expressed or redeemable in foreign currency they are likely to be within the definition of ‘qualifying corporate bonds’ (QCBs) (see TCGA 1992, s 117).
It is beyond the scope of this article to consider the tax treatment of QCBs in detail, but basically where deferred consideration is received in the form of QCBs the gain on sale is calculated including the value of the QCBs. So in Mary’s case, if she receives £500,000 cash and £200,000 loan notes, the gain is calculated on proceeds of £700,000. However the part of the gain which relates to the QCBs is held over and only becomes taxable as and when the loan notes are disposed of by being repaid. However, such a disposal is not a ‘qualifying business disposal’ and no ER is due.
Again the legislation provides for an election to be made (under TCGA 1992, s 169R) to disapply the normal rules so that the gain relating to the QCBs is taxed up-front, but with the benefit of ER. However, there can be a significant downside to making the election should the purchasing company go bust and the loan notes are not repaid in full.
Because QCBs are not chargeable assets, any loss on disposal is not an allowable loss. Moreover, if a disposal is triggered by partial redemption or by liquidation of the purchasing company, the held-over gain is still chargeable, except that HMRC will allow a worthless QCB to be gifted to charity within TCGA 1992, s 257 (‘Gifts to charities etc.’), without triggering a held-over gain (see Revenue Interpretation RI 23). If an election under TCGA 1992, s 169R is made those issues do not arise because of course CGT is paid up-front on that part of the consideration. However, if the purchasing company were unable to repay the loan notes in full there is no provision to enable any adjustment of the gain, and so CGT would have been paid (albeit at only 10%) on monies not ultimately received. This obviously poses something of a dilemma.
QCBs v ‘simple’ debt
If there is any doubt as to whether loan notes in the form of QCBs are likely to be repaid in full and appropriate guarantees or security is not forthcoming, the loan notes could alternatively be structured as non-QCBs though this does involve a foreign exchange risk, or, the deferred consideration may be structured as a simple debt.
In the latter case, the provisions of TCGA 1992, s 48 (see above) allow for a claim be made for the original gain to be recalculated based upon the consideration actually received, and while this does mean that all of the CGT is initially payable up-front, full ER is available and it is possible to recover some of the CGT paid if the debt should go bad.
Practical Tip :
It should not be forgotten that the sale of shares in an unquoted trading company usually involves exchanging an asset qualifying for 100% business property relief for IHT purposes for cash and/or debentures, which are 100% taxable. The sale of one’s family company therefore may need to be accompanied (or possibly preceded) by some estate planning. ‘Out of the frying pan, into the fire’, one might say!