The eventual exit from a business can provide a reward for the years of hard work and dedication. To achieve this goal, it is key that tax implications are considered correctly for all stakeholders to ensure that the best position can be achieved.
The business founders will want to ensure that they obtain Entrepreneur’s Relief (ER) on the cash proceeds received, and the associated 10% tax rate. Broadly they will be required to hold at least 5% of the ordinary shares, providing them with 5% of the voting rights and 5% of the proceeds on a distribution or sale. They will also need to be directors or employees of the company or a company within the group being sold. These conditions generally need to be met for two years before sale.
To the extent that they receive equity consideration or loan notes, the tax consequences are likely to be deferred. However, in some situations, shareholders elect to pay the tax upfront and claim ER now, as they may not meet the conditions to claim it at a future point.
Where the founders continue to work in the business, any earn out or contingent consideration needs to be carefully structured to ensure it is not treated as employment income by HMRC, and taxed at up to 47% in their hands.
As discussed, EMI options can effectively provide employees with value taxed at only 10%. It is important that the scheme is registered properly with HMRC, and reported on an annual basis to ensure that the benefits are not lost at the time of exercise and sale. Amongst other conditions the employee also needs to continue to meet the working time requirement throughout the period of holding the options – 25 hours a week or 75% of their working time in the relevant company.
By contrast, an employee participating in an unapproved option scheme would suffer up to 47% tax on an exercise and sale, no different than if they had received a cash bonus of the same amount.
Enterprise Investment Scheme (EIS) shareholders
For external shareholders who have claimed EIS relief, from a tax point of view at least they will not wish to sell their shares within a three-year period of issue. If they did, they would not qualify for the EIS Capital Gains Tax (CGT) exemption on sale and perhaps, just as importantly, would suffer a claw back of any income tax relief claimed at the point of investment. This can sometimes lead to tension between EIS investors and founders, in the event that a sale arises more quickly than was originally anticipated. Typically, the Articles of the Company contain ‘Drag and Tag’ provisions, forcing the minority shareholders to sell their shares at the same time as the other shareholders.
A key point to raise is that arrangements made during the three-year period, to realise a sale after this point fall foul of anti-avoidance rules. This would include the issue of options to sell shares at some point in the future.
It is also worth noting that a partial sale of the company not involving EIS shareholders could also breach EIS, if another company was deemed to obtain control of the EIS company at this point.
Other external shareholders
The default position is that they would suffer the standard 20% CGT rate on a disposal. However, with careful planning it may be possible for them to claim Investors Relief (IR) and reduce their gain to a 10% tax rate. One condition to be met here is that the shares need to be newly issued on acquisition and held for a three-year period before sale.
There are a number of valuable tax reliefs and incentives available for technology businesses and their investors to benefit from. It is important that businesses are aware of them and understand the nuances of the various regimes to ensure that they achieve an optimal tax position, providing the company with a strong platform to be successful.
For further information please contact Stephen Hemmings, partner at Menzies LLP on 020 7465 1968 or email [email protected]
Menzies is a top 20 leading firm of accountants, finance and business advisors that operate out of a network of offices across Surrey, Hampshire and London, providing our clients with easy access and local knowledge. Described as the ‘best performing firm outside of the top 10’ by Accountancy Magazine, Menzies has over 400 employees and an annual turnover of more than £40m.