The way that transactions are structured is likely to change forever thanks to an unexpected consequence of the changes to the Capital Gains Tax (CGT) regime.

When the coalition Government made their emergency budget in June, it was widely anticipated that CGT would rise, and the increase to 28% was generally felt to be an acceptable level. Furthermore, the extension of Entrepreneurs’ Relief (ER) to £5m and the retention of the 10% rate on qualifying gains was a bonus.

However, when the finer details of the legislation were digested, a twist in the tale was uncovered. ER was previously obtained by reducing the chargeable gain by 4/9s which, when subsequently taxed at the prevailing rate of 18%, resulted in an effective rate of 10%. Under the new rules, with alterative CGT rates dependent on levels of income, the technical application was simplified – qualifying gains are simply taxed at 10%, which is good as a basic principal.

What was not immediately understood was how this impacted deferred gains – eg. those arising from loan notes and qualifying corporate bonds (QCBs). Because the chargeable gain was arithmetically reduced before being taxed previously, ER was effectively locked in at the point of disposal. Now, however, ER is applied to the gain when it becomes chargeable to tax – at which point the asset is unlikely to be one qualifying for ER, for one of the following reasons:

• Not a 5% holding in ordinary share capital or of voting rights;
• The individual may no longer be an employee;
• The company may no longer be a trading company.

This creates a significant issue for individuals considering the disposal of their personal company. If we take as an example a gain of £5m, fully qualifying for ER at the time of disposal, deferral of the full gain into a form of loan notes could cost an individual £900,000!

The majority of deals in recent years have been structured with a large element, if not all, of the consideration being deferred. Whilst this has suited the vendor, it has also been dictated to an extent by the purchaser, looking to tie in the vendor to a deal and perhaps only pay the full proceeds by way of an earn-out in the event of continued performance.

Going forward, the options available to taxpayers are:

1. Take full cash proceeds. This could qualify fully for ER, thus securing a 10% tax rate; however, this would require the acquiescence of the purchaser, and may compromise the headline price.
2. Take loan notes, but elect to disapply the legislation to the effect that there is no charge to tax. This would crystallise the gain at the time of disposal and secure ER. However, the tax liability would potentially be unfunded when it falls due.
3. Take loan notes, and pay the tax when they are encashed. ER would only be available on any cash element received on Day 1, meaning that the future redemption could be liable to tax at 28%.

Consequently, the resultant tax rates on future disposals could be anywhere between 10% and 28%, subject to each taxpayer’s particular circumstances. It is therefore vitally important that advice is sought to give the most tax efficient structure. It is likely that the answer will involve a combination of cash and loan notes, and will be bespoke to each transaction. Indeed, it may be beneficial to take different types of loan notes – both QCBs and non-QCBs – to maximise the tax efficiency from the available elections. It is probably also worth pointing out that, whereas before QCBs were seen as the preferable option as they effectively locked in a tax rate on a predetermined amount, non-QCBs are likely to enjoy a revival since they will only trigger a tax charge on the actual amount redeemed.

There is no indication that the knock-on effect on loan notes following the CGT change was a deliberate and conscious decision by the Government. What is clear, however, is that taxpayers now have a difficult and potentially costly decision to make.