Tax directly – and significantly – changes the price and return from M&A transactions, so it’s surprising that often it isn’t given earlier expert consideration. We often get called to fix a problem with a deal, but retrospective action can be too late. If you want a smooth no-surprises transaction, it’s best to get the right advice early on. Here are some of the things we’ve seen at a late stage recently.
Missing out on Entrepreneurs’ Relief
Many individual sellers hope to benefit from Entrepreneurs’ Relief (ER), so that the rate of their Capital Gains Tax (CGT) is halved from 20% to 10%. The conditions to get this relief can seem straightforward, but we’ve seen instances where:
1. A selling shareholder resigned as company secretary / director in anticipation of a sale (reasonably concluding that this was appropriate as he would not continue in this role after the sale). Unfortunately, this meant the conditions for ER ceased to be satisfied and he was taxed at the 20% rate on the sale of his shares.
2. The sellers of a business assumed they would get ER and signed a letter of intent with the purchaser. However, the price mechanism in the letter of intent was such that no cash in the company would be paid for by the purchaser; this meant they had to take dividends of the cash and pay tax at the dividend rate of 38.1%, rather than at the ER CGT rate of 10% they had expected.
3. A client had been assured by legal advisors that ER would be available, but this was incorrect due to earn-out rights. The further cash consideration paid, above the amount estimated when the Share Purchase Agreement (“SPA”) was signed, was not covered by ER and so the client was taxed at the higher CGT rate of 20%. The client was also not made aware of the need to go through a valuation process with HMRC as part of filing their self-assessment tax return. It is important that sellers consider the tax position carefully before accepting a cash earn-out right. Well-advised sellers might want to negotiate to structure the deal as a ‘reverse earn-out’ right.
Getting the tax covenant wrong
A tax covenant is a mechanism for the seller to pay to the buyer, pound for pound, an amount equal to any (usually unexpected) tax due by the Company sold (in respect of the period before the sale is completed). The tax covenant is, in effect, a price-adjustment mechanism, so it is well worth getting it right. But we’ve seen cases where:
4. The notice provisions (due to the way they interacted with provisions of the tax deed) were so unclear it wasn’t obvious how a buyer would give notice to the seller under the tax covenant. This risked the process used being open to legal challenge, and the buyer then not being able to claim potentially significant amounts of tax.
5. A seller’s accountants, who were responsible for reviewing the tax covenant before it was included in the SPA, made no amendments to the documents – despite these being based on significantly out-of-date styles with now incorrect legislative references.
6. A seller disclosed nothing against the tax warranties when it was clear there were disclosures to be made; the seller thought his lawyers would do this (as they had for the other warranties), and the lawyers believed they could rely on their engagement letter stating they were not responsible for tax matters. While the law firm had protected their own position, the client perception was not that they had received the assistance they expected to protect their interests.
7. A buyer’s lawyer stated he was happy to use his “usual form” of tax covenant despite the fact this did not tie up with the price mechanism set out in the heads of terms and SPA.
8. Sellers realised (after a claim had been made against them by the buyer) that the (buyer-favourable) drafting in the tax covenant gave them no rights to require any defence be made by the company they had sold against the HMRC claim for tax; which the sellers were on the hook for under the tax covenant.
Risks from lack of knowledge and clarity
No-one can be an expert on everything, so it seems sensible to consult with the right people at the right time. But we’ve seen:
9. Buyers and sellers arguing at the Completion Accounts preparation stage over the types, and amounts, of tax to be included in Completion Accounts. This was because the drafting in the SPA and tax deed (which had to be read together) was unclear on what was to be provided for in, and excluded from, those accounts.
10. Incorrect references to, and confusion over, which of “accounts”, “consolidated accounts”, and “completion accounts” should be referenced in the tax covenant, tax warranties and SPA.
The risks arising where tax-related elements of a transaction are incorrectly dealt with in the SPA are considerable. The usual period for claims to be brought under a tax covenant (or for breach of tax warranties) is seven years. This significantly exceeds other usual warranty and indemnity claim periods, which are commonly 18 or 24 months. This long period can even be even longer (say, to 20 years) if a tax authority brings an assessment under certain provisions. This is a significant period for a document to be potentially open to scrutiny from clients and other advisors if/ when tax-related claims come to be made under it.
So…talk to tax experts early in the M&A process
There is no substitute for engaging early with tax advisors on a proposed M&A deal. If this is done at the letter of intent / heads of terms stage, mistakes like the above can be avoided. The parties, together with their respective legal advisors, can clarify who will be responsible for the tax-related elements of the transaction and get expert insight from someone who understands the tax covenant and tax warranties and how they interact with the price and with the rest of the SPA.
CT has a team with extensive experience in dealing with tax on M&A transactions, including team members who have experience working in law firms. We would be happy to discuss how we could assist law firms, other professional advisers or their clients to ensure the tax-related aspects of a deal are appropriately dealt with and the transaction achieves the tax expectations of the parties.