Capital Gains - Great Expectations

KEVIN SLEVIN FTII, ATT takes a look at the capital gains tax problems which arise with contingent consideration.

WHILE 'GREAT EXPECTATIONS' cannot be a very original title for an article about contingent consideration, I would like to think the suggested solution to some of the problems existing in this area of tax law is a lot more original. This article focusses first on the anomalies of the current system, anomalies which too many practitioners seem to lose sight of, and secondly on an alternative way ahead, a suggested solution that takes advantage of the self-assessment system. Any reader advising on either the capital gains tax taper relief provisions, the new corporation tax substantial shareholding exemption or land transactions of a capital nature should read on.

The problem

In my recent article 'Too Hot To Handle' (Taxation, 21 November 2002 at pages 184 to 185), I alluded to a problem concerning deferred unquantifiable contingent consideration and Schedule 7AC to the Taxation of Chargeable Gains Act 1992 (as introduced by Finance Act 2002 for disposals on or after 1 April 2002). Similar problems arise in respect of taper relief under Schedule A1 as regards both the meaning of business asset and the period of ownership that determines the rate of taper relief. Following the response I have received to that article, it is clearly a matter about which many tax advisers feel 'something should be done'. I thought, therefore, that I should clarify the issues and set down my thoughts on a possible solution. The Law Society has highlighted this issue in recent years as being a matter requiring attention, and readers seeking further analysis of the subject should refer accordingly. (For the avoidance of doubt, I am solely to blame for the content of this article and, in particular, for the possible solution put forward therein.)

Setting the scene

In 'Too Hot To Handle', I alluded to the fact that, while a company within paragraph 18 of Schedule 7AC (a sole trading company or a member of a qualifying group) disposing of shares comprising a substantial holding (defined by paragraph 8, broadly, as a holding of not less than ten per cent, but see paragraph 8 for the full picture) in a company within paragraph 19 (i.e. a trading company or the holding company of a trading group) might pay no corporation tax on the consideration received for the share sale if all the conditions of Schedule 7AC were shown to be satisfied, there was, however, a pitfall.

That pitfall is that no such exemption would apply to a capital gain in so far as it is attributable to deferred contingent unquantifiable consideration receivable under the terms of the share disposal contract in question.

It is well known that unquantifiable consideration of this nature falls to be taxed in the manner confirmed by the House of Lords' decision in Marren v Ingles [1980] STC 500, as if it is derived from an asset quite separate and distinct from the substantial shareholding disposed of. Yes, the open market value of the right to possible further consideration is added to the immediate consideration (and this element of the consideration will be exempt if Schedule 7AC applies), but the separate asset, i.e. the entitlement to receive the deferred consideration, in legal terms known as a chose in action, must be regarded as a quite distinct asset from the assets disposed of under the share disposal contract. The aforementioned contract creates the so-called chose in action.

Only a spectator to a transaction possessing a fine lawyer's brain could see matters in this light. I cannot recall any client of mine saying anything remotely like 'I have received an offer for the shares in X Ltd, and not only is the buyer offering me cash, but he is throwing in a chose in action too!'. There was that one occasion when one of my clients made an offer to acquire the shares in a company saying he would pay £X million cash plus give the vendor a valuable piece of incorporeal property which might increase in value or fall in value. Sadly, he never heard from the target company.

The reality of the Marren v Ingles decision of the Court of Appeal (confirmed by the House of Lords) is that the decision is not based in the real world, rather it creates a legal myth. The winning arguments advanced in the case gave the right result, i.e., it is unlikely that anyone in these times would argue that the Revenue was wrong in pursuing tax at stake, but was this really the end result the draftsman intended? For example, it is difficult to believe that the draftsman anticipated that his efforts would result in the need for an open market value to be established in respect of each and every occasion on which a chose in action is created under a contract relating to the disposal of a chargeable asset. Had he done so, would he not have sought to legislate specifically on the matter?

Taper relief blighted too

It is not just the effectiveness of the substantial shareholding exemption that is undermined by the Marren v Ingles decision. The arguments of Mr Marren, the Inspector, cast a shadow over the taper relief provision too.

The first problem with taper relief is that any capital gain attributable to the realisation of chose in action cannot fall within the category of assets considered to be business assets. This is so, whether or not the contract giving rise to the chose in action in question related to the disposal of a business asset.

The second taper relief problem is that taper relief at the non-business asset rate runs only from the date of the contract which creates the chose in action. Accordingly, unless there is an interval of at least three years between the disposal of the 'old asset' and the date on which entitlement to monies under the chose in action comes to pass, the gain on the deferred consideration will not attract any taper relief whatsoever.

More conflict?

In 'Too Hot To Handle', I highlighted the issue of conflicts of interest which could easily arise between different shareholders in the same company as a result of their different scenarios. Imagine now two shareholders in Target Ltd. One, a corporate shareholder, ABC Ltd, is hoping to benefit from the substantial shareholding exemption; the other, Susan, is an individual hoping to claim maximum taper relief. Both shareholders sell their shares and each receives cash plus the potential benefits of an earn-out agreement. The question to be addressed is how much value is to be attributed to their respective earn-out rights? Susan is worried about accepting a high figure because she has serious doubts as to whether any amount will be received. Even with the cash from the sale, she does not feel she can afford to pay ten per cent of a notional sum if, at the end of the day, she receives nothing under the earn-out agreement. Susan's tax adviser points out that if she receives less than the value initially attributed to the chose in action and taxed along with the cash proceeds, she will ultimately be able to claim loss relief but Susan is not impressed with this.

Worth a little, but not a lot

Susan instructs her tax adviser to argue that the value of the earn-out is very low. Susan points out that, as a soon-to-be former minority shareholder in Target Ltd, she has little idea of the real value of the right to potential sums under the earn-out. She has very limited information on what is really happening at the company, apart from that presented to shareholders at the annual general meeting, and she can do little more than hope that what she sees as 'the second instalment of the money due under the contract for sale' will come to pass. Susan is effectively being taxed on her expectations: 'Tell the taxman my expectations are low', says Susan.

Worth a lot, not just a little

The advisers to ABC Ltd take a different view, however. ABC Ltd's advisers realise that:

(a) the greater the value that is attached to the earn-out rights (and which, therefore, is taxed initially) the greater is the total tax exemption to be enjoyed under Schedule 7AC, and

(b) the greater the amount included initially under (a), the greater is the company's allowable loss in the event that the earn-out out produces a sum lower than that initially attributed to it.

Yet, despite the fact that the transaction creating the chose in action gives rise to an exempt gain under Schedule 7AC, any fall in value shown on the crystallisation of the earn-out creates an allowable capital loss.

Needless to say, the instruction to ABC Ltd's advisers is to argue that the value of the chose in action is high.

Section 138A

Section 138A, Taxation of Chargeable Gains Act 1992 helps, but it applies only where the deferred consideration is to be satisfied by way of the issue of loan notes. Yes, convoluted contractual provisions can be developed to bring transactions that would not otherwise fall within section 138A within it, but should this merry-go-round (often expensive in terms of professional fees, bank guarantees, etc.) really be necessary? Furthermore, section 138A cannot help with land transactions.

Land transactions

In many ways land transactions create more anomalies in this area than do other asset disposals.

All too frequently, land may sold with some expectation of planning consent being granted in years to come. With high hopes, taxpayers often agree to pay immediate tax on a notional sum that is added to their actual cash consideration only to discover that their hopes that planning consent will be granted are dashed, but their tax bill is not. Their only comfort is the ability of the taxpayer to argue that he has made a capital loss, i.e. when it becomes clear that their earn-out rights have fallen to a negligible value or that they simply have ceased to exist as assets. Proving the rights are of negligible value may not be straightforward. possibly requiring further professional fees. Who wants to incur such fees, when even the loss in question will effectively be subject to taper relief if it is to be set off against a gain on an asset subject to taper relief?

Time for another election

In my view, the decision in Marren v Ingles was just a means to an end. It was not unreasonable for tax to be paid on both the immediate consideration plus the ultimate consideration. The upshot was that the immediate consideration plus an amount equal to the open market value of the chose in action was held to be taxable in the year of disposal while the deferred consideration ultimately received, as reduced by the 'value' thereof taxed in the year of disposal, becomes taxable in the year the chose in action bears fruit, so to speak.

My suggestion is a simple two-fold proposal with effectively one set of rules for companies and another set of rules for individuals, trustees and personal representatives. It does not involve abandoning the Marren system, but merely sidelines it, so that it only applies where the taxpayer opts for it to be applied (or possibly to transactions between connected persons). The existence of such an election should mean there would be no losers under my proposal, apart from my fellow tax professionals and valuation experts. Such an election could be made easy under self assessment.

Most tax advisers will be able to draw a distinction between an earn-out transaction relating to the sale of a business, business asset or the sale of shares in a trading company, when compared to deferred contingent consideration receivable in respect of what I shall call 'passive assets' for this purpose, say arising out of a contract for the sale of land (including buildings). Essentially, my proposal is that a distinction is drawn for tax purposes between contingent consideration arising following disposals of business related assets and the so-called passive assets referred to above, as follows:

Step One: Introduce a provision deeming any contingent consideration received as a result of the payer having entered into a binding obligation to pay the contingent consideration as part of an agreement to acquire either:

• a business asset for taper relief purposes, as far as the vendor is concerned; or
• a qualifying substantial shareholding for corporation tax purposes, as far as the vendor company is concerned;

to be treated as being an identical 'business asset' for taper relief purposes or an identical 'substantial shareholding' for corporation tax purposes. While leaving contingent consideration taxable in the year of receipt:

• any contingent proceeds attributable to a substantial shareholding would be exempt from corporation tax; and
• any contingent proceeds linked in the manner suggested to a business asset previously held would give rise to a capital gain attracting taper relief in an identical manner to the old asset. (Indeed, where the taper relief provisions effectively require the old asset to be treated as two assets for taper relief purposes, the contingent consideration could likewise be taxed as if it arose in respect of two disposals - see passive assets below.)

Step Two: Other assets: Introduce a provision deeming any cash consideration received from the purchaser of an asset under a contingency provision included in the terms of the purchase agreement, to be treated as though it were consideration received on the disposal of a chargeable asset acquired on the making of the aforementioned agreement. Accordingly:

• such deferred contingent consideration received by a company would be deemed to be a capital gain in the accounting period it is received;
• while, say, 40 per cent of such consideration received by an individual, trustees or by personal representatives, etc. could be treated as giving rise to a capital gain in respect of a non-business asset for taper relief purposes with the balance being treated as a capital gain not eligible for any taper relief.

The above represents just a wish list but, think what it would be like to be able to focus on the commercial aspects of a transaction involving deferred contingent consideration without having to worry about the Marren system. Some taxpayers might be put off by the danger of ultimately paying more tax in respect of the assets described above as passive asset, and they can elect to continue the lottery of the Marren system. Furthermore, it might be necessary for transactions between connected persons to continue to be assessed under the present system to prevent tax avoidance.

Generally

Could this be a simple and cost effective solution? In the short term, the Chancellor might face an insignificant drop in tax receipts, but this would partly be a timing issue. Furthermore, any such drop in receipts will be reduced as tax planners set about creating sale structures that circumvent these problems where they are spotted in advance. In the long term, some taxpayers, i.e., those non-corporate taxpayers disposing of non-business assets would end up paying more tax. If you have a better idea, other than abolishing capital gains tax, why not let the editor know.

Kevin Slevin is a tax partner with Solomon Hare LLP, the Bristol based chartered accountants and taxation consultants. He can be contacted on 0117 933 3191, e-mail: kevin_slevin@solomonhare.co.uk.

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