The sale of trading companies are often structured in such a way that allow the seller to benefit from very low capital gains tax rates of only 10%, with the use of entrepreneurs relief. It is therefore rarely tax efficient to extraction cash from a company prior to a sale of shares. Nevertheless, once surplus cash levels within the company are determined, which in broad terms refers to cash which is not needed for the day to day running of the business, a purchaser often requires the buyer to extract the surplus cash prior to the sale. This can occur particularly if the buyer is unable to use the surplus company cash itself to finance the company purchase. The most practical way to extract surplus cash is usually for the seller to pay themselves a dividend. From a legal perspective it is necessary for the company to have sufficient “distributable reserves” from which to make this dividend payment. Distributable reserves are typically the cumulative post tax profits of a company, less any dividends which have been paid out during the life of the company. It is illegal under Company law to pay a dividend if there are not sufficient distributable profits.
Another common tax planning strategy used by shareholder-directors to extract cash prior to the sale of a company is to pay themselves a £30,000 tax-free ex-gratia payment. Where such a payment coincides with the sale of a shareholder’s shares in the company caution is required as HMRC often disallow the tax-free status of such a payment on the basis that the payment is linked to the sale of the shares. For a £30,000 ex-gratia payment to benefit from tax free status it is necessary to demonstrate that all the shareholders will receive full market value for their shares and that the termination payment was an independent transaction and was made for valid commercial reasons unconnected with the sale of the company. Further dangers arise if the person receiving the ex-gratia tax free payment is approaching retirement age as HMRC may attempt to treat the payment as representing an ‘unapproved pension benefit’ and hence tax it on the shareholder-director as employment income. The rules concerning the taxation of termination payments are complex and were changed in 2018. Expert advice should therefore be sought to confirm whether a payment made prior to the sale of shares is likely to be regarded as tax free.
It is important to remember, before contemplating pre-sale strategies, that if the planning is not carried out properly and in accordance with tax law it may be vulnerable to challenge. An intermediate tax planning step should never be inserted into a sequence of events to reduce exposure to tax if the ultimate transaction has certainty of completion as this is generally viewed as tax avoidance and HMRC have wide ranging powers to cancel any tax savings arising in these circumstances and charge onerous interest and penalty charges.
The advice in this column is specific to the facts surrounding the questions posed. Neither FPM nor the contributors accept any liability for any direct or indirect loss arising from any reliance placed on replies.