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Replies to Queries - 1 - Risky business

20 January 2003
Issue: 3891 / Categories:

Our clients are director and shareholders in an insurance brokers whose balance sheet shows net assets of £100,000. Goodwill is estimated to be £600,000.

Director A has 2,000 £1 shares (and wants to retire in three to five years' time when he will be 60). Director B has 1,000 £1 shares. C will also become a director/shareholder within the next few months, but has only £20,000 to invest. B will also raise £50,000 to acquire new shares at the same time.

Our clients are director and shareholders in an insurance brokers whose balance sheet shows net assets of £100,000. Goodwill is estimated to be £600,000.

Director A has 2,000 £1 shares (and wants to retire in three to five years' time when he will be 60). Director B has 1,000 £1 shares. C will also become a director/shareholder within the next few months, but has only £20,000 to invest. B will also raise £50,000 to acquire new shares at the same time.

What are the tax implications if B and C buy directly from A? Alternatively, should the company issue shares to B and C? If so, how many would be relevant, and what are the tax implications?

(Query T16,140) - Insurance.

The figures do not, at present, seem to add up. It appears that the company has a value in the region of £700,000 (assuming that goodwill is not reflected in the balance sheet). Director A apparently owns two-thirds of the issued shares, valuing his shareholding at something in excess of £470,000. Director B and C (an existing employee?) can afford to invest £70,000 in the next twelve months. A plan is needed.

* A could seek another purchaser for his shares (or the balance of them not sold to B and C).

* Can B and C buy A's shares in several tranches over the intervening years between now and his retirement or could the sale take place now (or at retirement) with deferred consideration?

* Is the current valuation, specifically the goodwill at £600,000, correct?

In a succession scenario such as this, many potential tax problems can arise; capital gains tax (retirement and taper relief), inheritance tax (business property relief considerations), company purchase of own shares, sections 160, 360 and 419, Taxes Act 1988 (relating to the issue and purchase of shares) amongst others. However, the more I look at this it seems that what we have is a cash problem rather than a tax problem, viz., there is a difference of at least £400,000 between what A could expect for his shares and what B and C can apparently afford to pay.

The company does have net assets of £100,000 and so could presumably afford to buy some of A's shares. Unfortunately, on the figures above, this would not seem sufficient to achieve the 'substantial' reduction (i.e. 25 per cent) in A's shareholding required by section 221(4), Taxes Act 1988.

I cannot see an immediate advantage in the issue of new shares to B and C, as this does not resolve the main question (for A at least) of realising the value of his majority shareholding.

The first step would seem to be to establish whether and how B and C can raise the finance to purchase A's shares - at least they have a period of three to five years to achieve this. The £70,000 presently available should be sufficient to purchase approximately 15 per cent of A's shares and, if this is done before the end of the current tax year, retirement relief is available.

It is assumed that A's shares have always been business assets for the purpose of taper relief. But it might be beneficial for all of the shares to be transferred into a discretionary trust (of which A is the beneficiary) before the end of this year to take advantage of retirement relief. The capital gain can be held over under section 165, Taxation of Chargeable Gains Act 1992; although the taper relief 'clock' restarts, as maximum relief is obtained after two years this should not be a problem in this case. Whatever approach, a careful watch should be kept to ensure that maximum taper relief remains available for future share sales by A.

In conclusion, assuming that finance can be arranged, share sales from A to B and C would appear to be the most straightforward route. B and C will acquire, and A will sell, business assets with potential maximum taper relief eligibility. Income tax relief in respect of interest on any loan to purchase the shares will be available under section 360, Taxes Act 1988.

As A is not planning to retire for a few more years, consideration should be given as to which of the following is most beneficial. The sale of shares in tranches over the years as resources become available to B and C: will this cause valuation (and control) problems as A's shareholding moves from a majority to a minority? A sale now with deferred consideration: but A does not wish to retire immediately, he will lose future income and there may be a risk (if the business did not perform well after his departure) that he would not receive the consideration in full. Finally, a sale on retirement.

A sale on retirement of the full majority shareholding for full consideration may be the most beneficial. - Lefty.

What is the issued share capital? The holdings by directors A and B amount to £3,000, an unlikely number. However, it is assumed that this represents the total issued capital, giving director A two-thirds control. To retain control, A and B should obtain bonus shares before C is allowed to subscribe for shares.

It would be unrealistic to suppose that dividends would sufficiently reward the investment by director/shareholders, nor is there any suggestion of possible capital gains from a sale or flotation. Even if not enjoying family connections, A and B have doubtless used their control, by mutual agreement, to obtain the fruits of their investments through remuneration or benefits.

The proposed changes could lead to disharmony unless A, B and C enter into a shareholders' agreement to regulate policy. Presumably A wishes to cash his shares to some extent so that fresh finance from B and C seems the obvious source, as the off balance sheet goodwill is merely an index of profitability. C can get tax relief under section 360, Taxes Act 1988 for interest paid on any necessary borrowing.

A should have separate advice on the encashment or utilisation of his (taxable) sale proceeds (some could be lent to the company or left as a debt from B or C).

The enterprise investment scheme (see Inland Revenue leaflet IR2000) is unavailable to B and C as working directors but subscription (rather than purchase) carries certain privileges. - M.C.N.

Issue: 3891 / Categories:
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