Upstream without a paddle
Why you should add S419(5) to the due diligence checklist.
From time to time I have the pleasure of putting to one side my corporation tax commitments and instead work along side our corporate finance team in carrying out tax due diligence, principally assisting banks with their investment decisions in private company acquisitions.
Along with the different working culture (very late nights for one), I find myself asking many different technical questions too, especially as most of the engagements I am involved with cover a large proportion of the tax spectrum.
Like me, I am sure those of you who carry out due diligence like to dig deep in the hope of coming across tax related “issues” that may not have already been considered so there is something exciting to report on. Now I don’t mean those kind of issues which could potentially run a deal into the ground, but those issues which are perhaps just on the radar for you to get noticed, especially if a long term relationship with the purchaser is on the cards (without breaching any conflicts of interest of-course!).
However, over the past 12 months I have been encountering one particular issue that keeps rearing its ugly head and is occasionally so significant that action does have to be taken. The issue I am referring to surrounds the application of Section 419(5) ICTA 1988 to certain structures put in place to allow for private company acquisitions and how it could lead to a tax charge under S419(1), the well know “loans to participators” charge.
In my experience raising this as a potential issue to the purchaser and any investors as part of the due diligence has resulted in wholesale changes to deal structures in order to avoid a S419 charge, which to me illustrates its significance.
Undoubtedly there are other issues that will spring to mind when discussing the acquisition of private companies especially in the kind of scenario I shall shortly illustrate (such as Section 703 clearance and financial assistance), but with my due diligence hat on, I am going to stick to the application of S419(5) for the purposes of this journal.
I will highlight the problem for you by way of an example. Lets us consider a relatively familiar type of commercial transaction:
Target company
Consider a close trading company XYZ Limited (“XYZ”) that is owned by two individuals A and B, who both feel that now is the right time to sell the majority of their investment in the company. The market value of the target company is £5m and the estimated balance sheet of XYZ at completion is as follows:
| Fixed assets | |
| Tangible assets | 500,000 |
| Current assets | |
| Stock | 150,000 |
| Debtors | 50,000 |
| Cash | 2,000,000 |
| Creditors due within 1 year | (650,000) |
| Creditors due after 1 year | (20,000) |
| Net assets | 2,030,000 |
| Share capital | 100 |
| P&L reserves | 2,029,900 |
| Shareholders funds | 2,030,000 |
As you can see the company has significant cash reserves available and the vendors would probably want to leave the cash in the company and increase the sale price accordingly, on the basis that they would bring all of the consideration into the charge to CGT and benefit from business asset taper relief (again, for the purposes of this journal I am not going to discuss business asset status – let us assume that full relief is available).
It may also be possible for any prospective purchaser to acquire XYZ by only having to externally raise up to £3m out of the £5m asking price. This is because the purchaser could potentially use the cash that is already in XYZ to pay some of the sale proceeds to the vendors on completion if an appropriate deal structure is put in place (discussed below).
This type of exit arrangement seems to be increasingly more popular as it allows the vendors to maximise their return on their investment by benefiting from the more favourable CGT rates and the purchaser benefits by not having to raise funds that essentially equate to the sale price. It is, however, this “self-funding” arrangement that is the crux of the problem discussed in this article.
Deal structure
Moving on, A and B agree to sell their shares to C for £5m on 30 June 2005, £4.8m of the consideration will be cash at completion and £200k of the consideration will be rolled over into new share capital in the acquisition vehicle. The period end for the new group will be 31 July 2005.
It is proposed that C sets up Newco Limited (“Newco”) to represent the acquisition vehicle, which will also be a close company going forward with three shareholders A, B and C.
Ignoring deal costs and working capital requirements, Newco is able to raise £2.7m of bank borrowings, C will invest £100k of equity in Newco and in addition XYZ has £2m on its balance sheet (as above) at completion which will be loaned to Newco immediately post acquisition in order to satisfy the cash consideration of £4.8m payable to A and B.
At this stage in the process the one would expect that clearance under S138 and S707 would have been applied for. On the basis that all clearances are obtained from HMRC and, despite a very late night at the vendor’s solicitors, the transaction completes on 30 June 2005. One would normally assume that, from a tax perspective at least, there are no further issues that could arise as a result of the deal structure.
The problem
Unless the S419(5) issue is dealt with early on in the process it may not be until much further down the line when the corporation tax return of Newco and XYZ is prepared that the problem is identified (by which time it could be too late!). When the computations to 31 July 2005 are drafted, Newco’s tax advisor would have hopefully noticed the “upstream loan” between XYZ and Newco in the statutory accounts and in his or her infinite wisdom realise that the loan was made to partially fund the acquisition of XYZ.
Naturally after a rush of blood to the head as any diligent tax advisor would do, the facts of the matter would be tested against the relevant legislation to see if a charge under S419(1), by virtue of S419(5) potentially exists.
Turning to S419(5), the wording of the section is as follows:
“Where, under arrangements made by any person otherwise than in the ordinary course of a business carried on by him—
(a) a close company makes a loan or advance which, apart from this subsection, does not give rise to any charge on the company under subsection (1) above, and
(b) some person other than the close company makes a payment or transfers property to, or releases or satisfies (in whole or in part) a liability of, an individual who is a participator in the company or an associate of a participator,
then, unless in respect of the matter referred to in paragraph (b) above there falls to be included in the total income of the participator or associate an amount not less than the loan or advance, this section shall apply as if the loan or advance had been made to him”.
In our example, we can see that a close company, namely XYZ, has made a loan to Newco. Given that the loan is to a corporate entity there is no S419(1) charge as a result of that transaction alone.
In addition, some person other than the close company (i.e Newco) has made a payment to an individual (two individuals in this case, A and B), who are participators in XYZ and clearly the loan was not made in the ordinary course of business.
Although this deals with the technical aspects of the legislation, in practice, to actually bring a charge under S419(1) by virtue of S419(5) the participators of the company that will make the loan have to stay participators in the same company at the point the loan is actually made.
This practical point was decided by the Special Commissioners in April 1988. Further commentary can be found in “Taxation of Companies and Company Reconstructions”, by R Bramwell QC.
In this case A and B are participators in XYZ at the time the loan is made because, in applying S419(7), they are participators in Newco on completion, given that Newco controls XYZ.
Therefore S419(1) would appear to apply and all of a sudden a real problem ensues for Newco’s tax advisors. Under the normal rules, if the upstream loan is not repaid by Newco before 1 May 2006 (i.e 9 months and one day following the period that the loan is first advanced) a S419(1) liability would arise on Newco in this case totalling £500k (i.e 25% of the upstream loan). Furthermore, one would assume that because the liability was clearly identifiable Newco would have to Self -Assess the tax.
In reality, it could be a few years before Newco is able to repay the loan – in whole or in part - to XYZ given its primary commitment is in repaying the bank loan. Hence it would be equally as long before Newco is entitled to a repayment of the tax under S419(4). In essence therefore, the S419 liability could become an absolute cost in the lifetime of the new owners of the company.
At this stage it would be worth mentioning that the same problem could arise if A and B were to dispose of their investment in XYZ for cash and loan notes. This is because the loan notes issued as consideration will by definition make A and B participators in Newco (by virtue of being loan creditors as defined in S417(7)) and therefore the same tax implications would apply.
For completeness if the sale was for cash only, then so long as A and B are not on the share register of XYZ when the loan is made there is no charge under Section 419. This is consistent with the Special Commissioners decision highlighted above.
Moving back to our original example, inevitably at some point in the compliance process the owners of Newco will have to be made aware of the issue, along with the bank that made the initial investment. I can envisage two questions from the concerned parties, is there a solution to avoid the tax charge and why wasn’t this picked up as part of the financial due diligence?
I don’t propose to dwell too much on the second question! However, as far as solutions are concerned there are two key stages which need to be considered.
Possible solutions
Firstly, if the problem is identified at deal origination stage, then the structure used to accommodate the transaction could be altered to avoid the problem in the first place.
This could involve the acquisition vehicle (in my example Newco) obtaining more bank funding rather than using an upstream loan. However the bank are likely to want security over the additional funding and this could be achieved by ring fencing the cash in the target company.
One would have to be careful in this arrangement not to allow Newco to repay the additional bank funds by borrowing cash from target post completion. This will bring the group straight bank into the realms of S419(5) as it is essentially the same as making an initial upstream loan!
Alternatively, if there are sufficient reserves on the balance sheet of target, then the deal structure may not have to be changed. Subsequent to any upstream loan being made on completion, the target could then pay a dividend to its new parent in order to clear the loan thus ensuring that S419(1) doesn’t come into charge, given that it will have been repaid by 9 months and a day following the end of the period.
Furthermore, there could be a way in which the participators of target could at completion be left off the share register, and then subsequently receive their shares or loan notes in Newco following the creation of the upstream loan, ensuring that the vendors are not participators at completion. Finally, if possible the vendors could just sell out for cash at completion! Therefore avoiding the issue all together (although this would change the deal dynamics completely).
As you can imagine, the only real solution available if the problem is spotted
post completion is to generate enough income in Newco in order to repay the
upstream loan in advance of the 9 month date. Fingers crossed there are sufficient
reserves to do this. I think it is safe to say that it would be in everyone’s
interests to have a game plan before the deal completes.
Conclusion
I imagine that in reading this there may have been one or two pauses for thought when reflecting on past transactions that you may have been involved with. As an after thought I must point out that there is very little HMRC commentary on the application of S419(5) and in my experience I have only seen one enquiry on this subject and I gather from speaking to those around me that even this is a more than frequent occurrence!
This has led me to believe that little consideration is given by HMRC in applying this aspect of tax law but as you can probably conclude the amounts involved are normally very substantial and therefore I think it warrants some thought at some stage in the deal process.
I have come to deal with this issue as part of due diligence and I can safely say that where it is a problem, it normally comes as a big surprise to investors, purchasers and sometimes even their tax advisors! However, the chances are a solution will be found and the problem goes away, but identifying the problem at an early stage in the process will give everyone more flexibility in arriving at a suitable answer.
To sum up, as I said early on in this article the application of S419(5), as evidenced from previous commentary and correspondence on the matter is not a well trodden area. However, given the generous rates of business asset taper relief I imagine that lots of deals are being structured whereby this piece of legislation becomes relevant. On a final note therefore, for those of you advising on transactions, whether through due diligence or general lead advisory, like me it would be worth adding S419(5) to your check-list of things to think about, so that non of us find ourselves dealing with upstream loans without a paddle!
Michael Tuhme is a Tax Manager of Tenon, leading accountants and business
advisers. Email: michael.tuhume, Tel: 0115 955 2000.
