On a sale of shares, proceeds of the sale may be paid in full on completion. Alternatively, part of the proceeds may be paid on completion, with the balance becoming payable at one or more future dates. In the latter case, there may be certain performance conditions attached to the future proceeds (typically related to the financial performance of the company) that must be met in order for the vendor to receive further payment.
The latter case is commonly called an “earn out”, and there are several tax points to consider when negotiating a sale of shares to ensure that the earn out is practical and tax effective for the parties involved.
Why Consider an Earn Out?
There are numerous reasons to have an earn out as part of a share sale. Typical reasons include:
- The buyer and seller may have differing views on the value of the company. The earn out can provide a commercial solution, by attaching further sales proceeds to a favourable future performance of the company.
- The earn out may require the seller(s) to continue working at the company/managing the business for a temporary period post sale, which can help ensure a smoother transition and incentivise existing staff/management.
- Where the seller expects the company to grow/be profitable going forward, the earn out can allow them to benefit from the future performance of the company.
Taxation
Employment Income
Where the seller was a director/employee and is contracted to work for the company post sale, there is a risk that any future earn out proceeds may be considered a reward for services rather than deferred consideration for the sale of shares. In such cases, the proceeds would be taxed on the seller as employment earnings, with combined income tax/national insurance (NICs) of up to 47%. The company would also be subject to NICs liabilities on the deferred proceeds.
For comparison, where the same proceeds were taxed under the capital gains rules and
entrepreneurs' relief was available, the full value of the gain would be taxable at 10% on the seller, with no further tax/NICs for the company.
It is therefore important that due consideration is given to the terms of the share purchase agreement/earn out, the nature of the payments, and the reasons for any continued employment.
Capital Gains Tax (CGT)
Where the CGT treatment applies, there are further tax considerations depending on the nature of the earn out.
Ascertainable Consideration
Where the deferred proceeds are ascertainable at the date of sale, i.e. they can be quantified with certainty at that date, then the deferred proceeds are treated as if they are received at the date of completion. The seller will therefore be subject to CGT on the initial sale proceeds, plus any ascertainable proceeds, in the tax year of sale. Hence, there may be a cash flow issue as they will need to pay CGT on amounts they have not yet received.
There are no further CGT implications where the proceeds are received at a later date, as they have been taxed in the year of completion.
Unascertainable Consideration
Where any future sale proceeds are unascertainable at the date of sale, then the seller will instead need to estimate the present value of the right to receive future proceeds (know as a ‘chose in action’). A
valuation is recommended. The chose in action part of the sales proceeds will be subject to CGT in the year of completion, along with any proceeds payable on completion, and so again there is a cash flow issue as the seller will be subject to CGT on proceeds they have not yet received.
If/when the proceeds are received at a later date, there may be further CGT to pay in the year of receipt where the actual proceeds are higher than the chose in action element. Alternatively, if actual proceeds are less than the chose in action part of the sales consideration, then an allowable loss will arise in the year of disposal.
Due consideration should be given to the conditions for entrepreneurs' relief, and how this will affect the overall tax position where unascertainable consideration is involved.
Conclusion
Structuring an effective earn out is complex, and there are several commercial and tax issues to take into consideration. We recommend obtaining advice early in the process to ensure that the final agreement is both commercially and tax effective for all parties.
If you require advice/assistance with the
sale or acquisition of a company/business, please
contact us.
