Taper Relief: the issue of loan notes by a purchaser on the acquisition of a company

United Kingdom
In the context of a private company acquisition, it is common practice for the purchasing company to issue debentures (loan notes) in itself to shareholders in the company acquired ("the Target") in satisfaction (or more commonly, in part satisfaction) of the price. This note looks at the tax issues that arise for individual sellers (but does not consider corporate sellers) and whether the proposed changes to taper relief expected to be enacted in the Finance Act 2002 will affect existing practice.

The issue of loan notes may be driven by the purchaser as a means of financing the acquisition but in many cases it is the sellers who stipulate that part of the price should be satisfied by the issue of loan notes. This is invariably required by the sellers for tax purposes. There are two main tax drivers for the seller:-

  • deferring tax on gains on disposal of shares in the Target, and
  • reducing the effective rate of tax by enhancing taper relief.
CGT deferral

A seller can avoid an immediate CGT charge to the extent that he receives shares or debentures as the "price" for selling his shares in the Target. Specific requirements must be met in order to obtain the relief, but, typically, these will be satisfied on a private company acquisition.

There are, broadly, two types of debentures or loan notes that can be issued as the price for selling the target companies shares; "qualifying corporate bonds" ("QCBs") or "non-qualifying corporate bonds" ("NQCBs"). Although a CGT deferral is achieved where shares are exchanged for either QCBs or NQCBs the tax treatment of the two types of debenture or loan note are very different. Where the debentures are QCBs the gain arising on the sale of the shares is computed at the date of sale and is then "frozen". On a subsequent disposal of the QCBs (eg on redemption) the CGT charge crystallises. A QCB is not a CGT asset and therefore no capital gain or allowable loss will arise on its redemption or other disposal; the disposal of a QCB simply serves to crystallise the charge on the gain that arose on the sale of the shares in the Target. Significantly, that crystallised gain ("frozen" at the date of sale of the shares) cannot be reduced by taper relief for the period (which could be a number of years) that the QCBs are held by the seller – see further below.

NQCBs, on the other hand, are CGT assets. Any gain that would otherwise be realised on the sale of the shares can be "rolled over" into NQCBs with those NQCBs being treated as the same asset as the shares in the Target. No gain arises on the sale of the shares; instead, the individual's acquisition cost (or "base cost") of his shares becomes his acquisition cost of the NQCBs. Any gain is therefore not "frozen" and a gain or loss will arise on the disposal of the NQCBs. Significantly, where the NQCBs are disposed of (eg on redemption) any gain that would have arisen on a cash disposal of the original shares will be reduced by taper relief. CGT rates may be reduced from 40 per cent to an effective rate of 10 per cent - see further below.

Debentures have generally been structured as NQCBs to ensure that the seller can trigger a capital loss if the purchaser defaults and cannot pay the full redemption price. If the debentures were, instead, structured as QCBs the individual seller would be left with a charge to tax on the "frozen" gain that arose on the sale of his shares in the Target and a non-allowable loss on the disposal of the debentures. As indicated above, the crucial distinction between debentures which are NQCBs and debentures which are QCBs, (i.e. where the debentures are NQCBs the shares and the debentures are treated as the same asset and the one is "rolled over" into the other) ensures that this cannot happen where the debentures are NQCBs. The risk of this happening where the debentures are QCBs can be reduced if the debentures are guaranteed (eg by a bank).

Enhancing taper relief

Immediately prior to the introduction of taper relief in 1998, an individual was liable to CGT at his marginal income tax rate (40 per cent for a higher rate taxpayer) on any gain arising from the disposal of his shares in the Target (subject to the availability of any specific but narrower reliefs eg retirement relief). The gain could be deferred by taking debentures (see above) but ultimately tax at 40 per cent would be payable (unless there was scope for more creative tax planning).

Taper relief was introduced in the Finance Act 1998 and applies to any disposal of shares (but not just shares) by individuals made on or after 6 April 1998. Broadly, it operates by reducing the chargeable gain arising on the shares, the extent of the reduction depending upon the length of time that the shares have been held and whether the shares are "business assets" or "non-business assets". Following changes in the Finance Act 2000, where a business asset which has been held for 4 years or more is disposed of, only 25 per cent of the gain is chargeable. This is equivalent to an effective rate of tax of 10 per cent (for a higher rate taxpayer). On the other hand, to obtain the maximum taper relief on a disposal of a non-business asset, the asset must be held for 10 years or 9 years for assets held on 17 March 1998 (in both cases excluding periods of ownership before 5 April 1998). If the maximum amount of non business taper relief is obtained then 60 per cent of the gain is chargeable, equivalent to an effective rate of tax of 25 per cent. Clearly it is more beneficial for the asset to be treated as a business asset.

The Finance Act 2000 also introduced a more generous business asset test. Prior to the Finance Act 2000, shares held by an individual would only qualify as a business asset if the company was a trading company or holding company of a trading group and the individual could exercise at least 25 per cent of the voting rights in the company or he could exercise 5 per cent of the voting rights and was a full time working officer or employee of the company (or of a relevantly connected company). The Finance Act 2000 (which applies to disposals made on or after 6 April 2000) provides that shares will qualify as a business asset if the company was a trading company or the holding company of a trading group and

  • the company is unlisted (shares traded on AIM are regarded as unlisted) and is not a 51 per cent subsidiary of a company that has any of its shares listed; or
  • the individual is an employee or officer of the company or of a company relevantly connected; or
  • the individual can exercise not less than 5 per cent of the voting rights in the company.

An individual cannot qualify for maximum business taper relief on a holding of shares until April 2002. If, for example, an individual held shares in the Target on 5 April 1998 and sold them for cash on, say, 7 April 2001 and during the whole of that period the shares qualified as business assets he would be subject to CGT on 50 per cent of the gain arising (an effective tax rate of 20 per cent). If he could be treated as holding on to the shares for an additional one year he would benefit from the 10 per cent effective rate. Therefore, in this example, the seller might ask the purchaser to issue loan notes (redeemable only after at least one year has elapsed) rather than pay cash. Provided that the loan notes are "securities" for the purposes of taper relief and either:-

  • the purchaser is not a listed company nor a 51 per cent subsidiary of a listed company, or
  • the seller is retained as an officer or employee or has 5 per cent or more of the voting rights in the purchaser,
then two things follow. First, the loan notes will be treated as the same asset as the shares the seller held in the Target. Second, business asset taper relief will continue to run (assuming that the circumstances were such that the shares qualified as business assets for taper relief purposes). Therefore, on redemption of the loan notes the gain arising will be taxed at an effective rate of only 10 per cent.

There has been considerable debate over the last year or so as to what qualities a loan note must possess in order for it to qualify as a "security" for the purposes of taper relief. There always were strong arguments for saying that a simple debenture is a security for these purposes. This is soon expected to be the strict legal position. Last November, the Inland Revenue announced that legislation will be introduced in the Finance Act 2002 to make it clear that a simple debenture will qualify as a security for taper relief purposes. This will apply to all disposals made on or after 6 April 2001.

The Revenue had previously not expressed a clear view on the subject but implied (see Tax Bulletin issue 53) that a loan note must be tantamount to a "debt on a security" for it to be a "security" for taper relief purposes. A "debt on a security" is a debt that is akin to an investment and which therefore should be marketable and have the capacity for the holder to make a profit or loss. Considerable time and effort went into structuring debentures so that they qualified as debts on a security.

Taper relief post 6 April 2002

From 6 April 2002 it became even more imperative that individual shareholders in a private company that is to be sold consider their respective tax positions. It may be the case that some shareholders will have different preferences from others.

If loan notes are to be issued on an acquisition of a Target then up until now it has invariably been to the individual seller's benefit for the loan notes to be structured as NQCBs (so that business taper relief can continue to run and a capital loss can be triggered on any default by the purchaser in paying the full redemption amount of the loan notes). Will this continue to be the case after 5 April 2002?

Suppose that an individual has held 4 per cent of the ordinary shares (and 4 per cent of the voting rights) in the Target since 1 January 1998 and that at all times he has been a full-time working employee. He sells the shares on 5 April 2002 and makes a gain of 100. For the period 6 April 1998 until 5 April 2000 the shares will have been held as a non-business asset. For the period 6 April 2000 until 5 April 2002 the shares will have qualified as a business asset. The legislation operates so as to apportion the gain pro-rata to the respective periods of business and non-business use. Therefore, 50 of the gain will attract taper relief at the business asset rate attracting an effective tax rate of 10 per cent (on the basis of a 4 year holding period). The other 50 will attract taper relief at the non-business asset rate attracting an effective tax rate of 34 per cent (on the basis of a 4 year holding period plus a one year bonus available for shares held on 17 March 1988). If the seller takes NQCBs that qualify as a business asset then whilst the NQCBs are retained the proportion of the overall gain that will attract business taper relief will increase whilst the proportion that will attract non-business taper relief will reduce. At the same time, that proportion of the gain that ultimately is subject to non-business taper relief will also bear tax at a lower rate because the holding period continues to increase.

From 6 April 2002 it became even more important to assess the particular circumstances of each shareholder in determining whether it is desirable for the loan notes to be structured as NQCBs. Where the shares held by an individual have always qualified as business assets and have been held for a period that attracts the minimum effective rate of tax (reduced to 2 years from 6 April 2002) the seller may decide that QCBs are preferable. The gain would be computed as at the date of the disposal of the Target and "frozen" as outlined above. If, instead he takes NQCBs then so long as the NQCBs continue to qualify as business assets he will be in no worse position. However, the NQCBs could become non-business assets if, for example, he does not have a 5 per cent holding in the purchaser, is not a full-time working officer or employee and the purchaser floats and becomes a listed company. The ultimate gain would consequently have to be apportioned thereby increasing the effective rate of tax.

Where the shares have qualified as a business asset for part of the time and as a non-business asset for the remainder eg see the example referred to above, then it will be desirable for the seller to take NQCBs (provided that they qualify as a business asset) so as to increase the proportion of the ultimate gain that will attract business asset taper relief.

If you would like any further information, please contact:

Richard Croker

Corporate Tax Partner

Phone: + 44 20 7367 2149

Email: richard.croker@cms-cmck.com

Simon Meredith

Corporate Tax Partner

Phone: + 44 20 7367 2959

Email: simon.meredith@cms-cmck.com

Mike Boutell

Solicitor

Phone: + 44 20 367 2218

Email: mike.boutell@cms-cmck.com