By Simon Denye, Partner, Dow Schofield Watts Tax Consulting LLP
Introduction to MBO’s and Corporate Tax Issues
Several new companies may have been incorporated and /or acquired as a result of a management buy-out (MBO). It is important that the directors of the new group are aware of the tax matters which may need to be addressed once the transaction is complete.
It is likely that a tax structuring report was issued by the tax advisers involved in the transaction, not only setting out the steps required to implement the structure for the transaction, but also the recommended actions and ongoing tax issues to consider once the MBO has taken place. A due diligence process will also have been carried out and the tax section of the report issued as part of this exercise should be consulted to ascertain whether any other action was recommended.
The members of the MBO team making the investment should ensure that they obtain their own tax advice covering the tax matters affecting them. These matters are not covered here in detail as this note deals with company taxation issues. They typically will need to consider:
- Tax treatment of earn-outs and deferred consideration
- Entrepreneurs’ relief
- Employment-related securities
- Restricted securities
Deductibility of interest costs
The MBO team is likely to have secured additional financing from external investors. It is possible that some of these institutions may have received shares in the new group in return for their investment, resulting in them being a connected party for corporation tax purposes. There are several provisions within the tax legislation which may restrict either the level or the timing of the interest deduction, particularly where there is a connection between the parties to the loan. The definition of ‘connection’ can vary depending upon which provisions apply.
Corporate interest restriction (CIR)
The CIR places a limit on the amount of interest expenses and certain other financing costs that large businesses can deduct when calculating the profits subject to corporation tax. The rules have effect from 1 April 2017.
The starting principle is that any group with a net interest expense in the UK below a £2m de minimis will not be subject to the CIR. Very broadly speaking, this will be the case where the group’s deductible interest expense in the UK exceeds the group’s taxable interest income in the UK by no more than £2m. Groups with a net interest expense above the de minimis will be subject to a cap on interest deductions under the CIR.
There are also various administrative and reporting matters that must be considered.
Application of transfer pricing principles
In the context of an MBO, the transfer pricing legislation will commonly apply where a number of persons act together in relation to the financing arrangements of a business and collectively, those persons are capable of controlling the company. The acting together provisions will need to be considered.
If the transfer pricing rules do apply, the rate of interest payable under the terms of the financing agreements in place must be charged on an arm’s length basis. If HMRC determines that the rate of interest is not arm’s length, it will seek to restrict the amount that is deductible for corporation tax purposes. What is considered to be arm’s length will vary depending upon a number of factors, e.g. the prevailing rates of bank interest at the time of the transaction, agreements that other companies operating in the same industry have agreed with third parties etc
The directors may wish to enter into an advance thin capitalisation agreement (ATCA) with HMRC to set the quantum of interest that may be deductible for forthcoming accounting periods. This will assist with cash flow forecasting and quarterly instalment payments planning.
Late interest provisions
The loan relationships legislation imposes a restriction on the timing of interest deductions in certain circumstances. Where these provisions apply, a deduction will only be available when the interest is actually paid, as opposed to merely being accrued, if it is not paid within 12 months following the end of the accounting period.
An investment company which has a purely financing function (such as a company incorporated for the purposes of an MBO) may generate excess non-trade loan relationship deficits during an accounting period as a result of the interest costs it bears on its loans. Historically, this sometimes gave rise to ‘trapped losses’, where the losses could not be surrendered to other group companies in the accounting period in which they were generated, and the losses accumulated year on year. This is because these companies often do not generate any profits against which the losses could be utilised, as they simply provide a financing function. This is an important point to consider when prioritising the allocation of losses for group relief purposes.
The rules governing the way in which losses can be utilised changed with effect from 1 April 2017, and the problem of continued trapped losses is now likely to be avoidable. Losses incurred from 1 April 2017 may be carried forward and utilised against different activities of the same company or another company in the same group. This is a radical relaxation of the previous rules giving rise to the situation where losses can quite easily become trapped within individual companies. However, the offset of losses is also restricted to 50% of profits in excess of £5 million. The computational provisions are complex and cover a large number of detailed steps. Careful analysis will be required during and following the MBO process, to ensure losses are utilised in the most tax efficient way.
Deductibility of transaction costs
A wide variety of costs will be incurred during the process of the MBO. This may include corporate finance fees, bank arrangement fees, legal costs, tax advisory fees, due diligence fees and so on. An analysis of these costs will need to be carried out to ascertain whether any of them will be deductible for corporation tax purposes. The difficulty here is that HMRC will often view many of the costs as capital in nature, as they relate to the acquisition of a capital item (i.e. shares in a company). It is also important that the invoices are issued to the correct company in the group (or recharged) to maximise the chances of obtaining a deduction. For example, the bank arrangement fees will not be deductible in the hands of the trading company in the group if the bank loan for the transaction was advanced to one of the investment companies.
Costs incurred for the purposes of securing financing for the transaction may be deductible under the loan relationship rules where they are incurred directly in:
- bringing any of the loan relationships into existence
- entering into or giving effect to any of the related transactions
- making payments under any of those relationships or as a result of any of those transactions
- taking steps to ensure the receipt of payments under any of those relationships or in accordance with any of those transactions
HMRC’s manuals also contain a list of specific deductions that are allowable as incidental costs of loan finance. Details of exclusions are also provided.
Tax deductions for loan relationships will usually follow the treatment applied in the accounts so it is recommended that tax and accounts collaborate to maximise the deductions available. In practice, it can be very difficult to convince HMRC that such costs are incurred directly, as in its view, the primary aim of the MBO is to acquire shares and not to obtain a loan. As much evidence as possible should be retained during the course of the MBO, such as loan agreements, which could be presented to HMRC in the event of an enquiry.
An investment company can deduct its expenses of management from its total profits, provided they are not capital in nature. Following the case of Camas, costs incurred up to the point a decision is made to proceed with the transaction should still be revenue in nature on the basis that the company is still managing its investments rather than actually making investments. In reality, this decision is usually taken early on in the transaction process which limits the level of fees which will be deductible.
In the context of a trading company, it is unlikely that many transaction fees will be deductible unless it can be demonstrated that they have been incurred wholly and exclusively for the purposes of the trade. In the context of an MBO, this is likely to be limited to fees incurred maintaining the ongoing operations of the business, dealing with staff matters, etc.
It should be noted that any costs borne by the group on behalf of the MBO team are deductible for corporation tax purposes as staff expenses, but should be assessed on the individuals as a benefit in kind as appropriate.
Break fees are generally designed to compensate one party’s legal and professional costs, which it may have incurred in due diligence and negotiations at the time a private company transaction terminates. They may also encourage the parties to remain at the negotiating table rather than take action that may unreasonably cause the transaction not to proceed. There are both direct and indirect consequences for the parties when such fees are paid.
Form 42 and other reporting requirements
The acquisition of employment related securities (and other reportable events) by the management team needs to be reported to HMRC by the company issuing the shares using form 42. The report should be made by 7 July following the tax year in which the taxable event took place.
Where PAYE has been applied, any relevant amounts will need to be recorded on the company’s relevant employment taxes records both for submission to HMRC and for inclusion on the relevant paperwork supplied to the employees (i.e. annual P60).
Implications of enlarged group for corporation tax purposes
A number of corporation tax issues will need to be considered following the creation of a new group as part of the MBO process.
The directors of any new companies created during the MBO have an obligation to notify HMRC when the first chargeable accounting period begins. Certain prescribed information will need to be supplied to HMRC, as set out in SI 2004/2502, reg 2. The directors must give written notice within three months of the start of the accounting period and the notice must state when the chargeable accounting period began. This information is usually provided on form CT41G which HMRC sends once it is notified by Companies House of a new company’s existence. It is also possible to inform HMRC that a company has become active using its online facility or the joint Companies House web incorporation service.
A corporation tax return will need to be submitted to HMRC within 12 months following the end of the accounting period of all active companies within the group. A ‘nil’ return may be submitted for any dormant companies, or the directors can send a copy of the dormant accounts to HMRC and request permission not to file a tax return.
Payment of corporation tax
Small companies are required to pay their full corporation tax liability within nine months and one day following the end of the accounting period. If the period exceeds 12 months, it is split into two periods, the first being the 12 months from the start of the accounting period, the second being the remainder of the accounting period.
The creation of an enlarged group may bring some (or all) of the group member within the quarterly instalment payments regime. This accelerates the timing of the tax payments that need to be made by those companies which are considered to be large or very large.
Restrictions on the use of losses
It is unlikely that all companies in the new group will have the same accounting period in the first period following the MBO. For example, any newly incorporated companies are likely to have a short accounting period. Consequently, care will need to be taken in allocating losses for group relief purposes where any of the accounting periods within the extended group are non-coterminous. Losses cannot be used for periods which do not overlap.
The use of losses can be restricted in other circumstances following the change in ownership of a company. This can occur when there has been a major change in the nature or conduct of the acquired business, or, in the case of an investment company, when there has been a significant change in the level or nature of investments held. N.B revised loss relief rules in force from 1 April 2017.
The stamp taxes which apply will depend upon the circumstances of the MBO transaction. Most commonly, stamp duty may be payable on the acquisition of shares at a rate of 0.5% of the consideration.
Changes to the group structure following an MBO can also give rise to VAT considerations. For example, if the group acquired by the management team already has an established VAT group, newly incorporated companies may need to be added.
Simon is a Partner in Dow Schofield Watts Tax Consulting LLP. He has over 21 years’ experience providing advice to a wide range of clients including large corporates, SMEs and high net worth individuals.