You sold your business a few years ago. The deal included an agreement which linked part of the payment to the company’s subsequent performance. Recent events have caused the business to slump. How might this affect the tax you paid on the sale?
Conditional payments
So called earn-outs are a common feature of selling a business. As an example, a buyer might offer the majority of the purchase price on completion of the contract and more over three years as long as the business hits turnover or profit targets. This type of arrangement can result in some tricky capital gains tax (CGT) calculations.
Taxing estimated gains
CGT is worked out on the initial price agreed in the contract plus any future amounts you’re entitled to. If the future amount depends on, say, how much profit the business makes it will have to be estimated and tax will be payable on this too.
Example – part 1. In March 2018 Bob accepted an offer for his business of £600,000 on completion of the contract and an amount equal to 30% of the business’s profits for the three years ended 31 March 2019, 2020 and 2021. A payment for each year is made after each year’s accounts are finalised. The profits are estimated at £200,000 for each. If all goes well Bob will receive another £180,000. Therefore, for 2017/18 Bob owed CGT on £780,000 (£600,000 + £180,000).
Note. Bob was entitled to claim the entrepreneurs’ relief (ER) (called business asset disposal relief for gains made after 5 April 2020)) rate of tax (10%) and so after knocking off his annual exemption he ended up paying just under £78,000 in CGT for 2017/18.
Example – part 2. When the accounts for 2019 are finalised in July that year they showed a profit of £250,000, i.e. £50,000 more than originally estimated. The buyer pays Bob 30% of this as agreed, i.e. £75,000, whereas the original estimate was £60,000. As long as there’s no reason to think that the original estimate of profits for the next two years is wrong he’ll have to pay CGT on the extra £15,000.
No ER
The bad news for Bob is that the £15,000 gain doesn’t qualify for ER. This means he must pay tax at the full rate, which as he’s a higher rate taxpayer is 20%. He can, of course, deduct his annual exemption (if he hasn’t used it) and any other relevant tax reliefs, e.g. capital losses, when calculating the tax. So far so good, but what happens if Bob’s old company under performs and he receives less than he’s already been taxed on?
Example – part 3. The company’s profits for 2020 came in at £120,000, i.e. £80,000 less than originally estimated. This meant Bob only received £36,000 in July 2020, but he’s already paid tax on the assumption he would receive £60,000. He’s therefore made a capital loss of £24,000 for 2020/21. The trouble is if he has no gains in that year it seems all he can do is carry the loss forward and hope he can use it against a gain in a later year.
Tip. The good news for Bob is that he can make use of an election to carry back the loss and reduce the tax he paid for 2017/18. This will generate a refund for that year of £2,400 (£24,000 x 10%, i.e. the ER rate of tax he paid in that year).
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.