Lucy Mangan – Partner
It has been said that the only two things in life which are inevitable are death and tax. Let’s set the scene: a husband and wife (Will and Maggie) are approaching retirement age and want to spend their twilight years travelling the world.
They don’t have much in savings as they have a number of kids who have proved to be funnels for their cash. However, they do have a very successful business which they have built up over the years.
Selling a Business: The Background
The business trades in making handbags but also has a property within the company which it rents out at a commercial rate. A multi-national conglomerate (Ponga) which also specialises in handbags would like to set up in the UK and sees this trade as their route in. Ponga offers Will and Maggie £18million for the business without the property and £20million for the company should the property be part of the deal.
So what should Will and Maggie do?
Option 1 – Sell the company with the property for £20million
At first, this looks like a good headline figure to receive but the taxman is always lying in wait to grab more of the proceeds. How this would be done here is if it is argued that the property makes the company a non-trading company.
If the company is considered a trading company and Will and Maggie meet the other conditions for entrepreneur’s relief, then their net gain should be taxed at 10% subject to their lifetime allowance. However, should HMRC take the view that the activities of the company include to a substantial extent non-trading activities due to the property rental business, then this gain would be taxed at 20% (the good news here being that prior to 6 April 2016, this was taxed at 28%).
HMRC tend to define substantial as 20% and to determine this they look at a number of indicators together including:
- Income from non-trading activities
- The asset base of the company
- Expenses incurred, or time spent, by officers and employees of the company in undertaking its activities
- The company’s history
- And a balance of indicators
The other problem with this option is that Will and Maggie are denied a steady rental income which would have formed part of their retirement fund to travel the world (or more likely to spend on their kids).
Option 2 – Sell the business for £18million
This option immediately addresses the above problem and allows Will and Maggie to retain the rental property. So this is the better option I hear you ask? Well not quite, as their other objective is not met this time.
Selling the trading business and relevant assets directly to Ponga and not the company itself, means that the proceeds will be in the company and not directly with them. The company will have to pay corporation tax at 20% on any trading profits and chargeable gains. Will and Maggie will then suffer an additional tax charge when they seek to withdraw the funds from the company. If this is done via dividends, the rates could be as high as 38.1%. Therefore, it they go for this option, there is a double tax charge!
There is a third option which could see the trading business sold and the proceeds being extracted as in option 1, with Will and Maggie keeping hold of the property rental business as in option 2. This would be done by an indirect demerger of the business with the intention to sell the trading business in due course. Post demerger, there would effectively be two companies owned by Will and Maggie, one with the trading business and the other with the rental business. The company with the trading business can then be sold extracting the proceeds immediately while they continue to enjoy the steady income of the rental property.
The indirect demerger can either be a s110 or a reduction in share capital demerger. The route chosen will depend on the particular circumstances and conditions involved. For example, while a s110 may be slightly more costly, there could also be positive unintended consequences which are not available with a reduction in share capital demerger.
This all sounds great, what could go wrong?
Expert guidance in undertaking such transactions should be sought as the penalties for getting it wrong could be severe and include the following:
- There could be substantial stamp duty land tax charges.
- There could be stamp duty charges.
- Incorrect implementation could lead to large corporation tax charges in the company and/or capital gains and income tax charges on the shareholders.
- Moving the property within the group could also trigger an Annual Tax on Enveloped Dwellings (ATED) charge if exemptions are not available.
Whichever method is chosen, approval must be sought from HMRC to ensure they agree that the transaction would be tax-neutral.