It’s common for larger companies that buy smaller ones to offer payment wholly or partly in loan notes. HMRC taxes these in one of two ways and as the person receiving them you can choose which. But what’s the most tax-efficient way to go?
Loan notes – Options
When a company buys another business one of the ways it can reduce, or at least spread the cost is to pay the seller wholly or partly in loan notes. Essentially these are IOUs, which usually come with restrictions on when you can cash them in. The advantage to you, as the seller, used to be that you didn’t have to pay capital gains tax (CGT) on the proceeds until you redeemed the loan notes. However, that changed in 2010.
Pay less CGT now, or more later
The 2010 change forced sellers to decide between a low CGT rate (10%), which applies when you sell a business that qualifies for entrepreneurs’ relief (ER), or delaying payment of CGT until you redeem the loan notes. Example. Jack sold his business to Acom Ltd for £1 million on which he made a capital gain of £250,000. The whole gain qualifies for ER. Jack received £500,000 of the proceeds as loan notes, meaning that £125,000 of the gain was rolled into them. Jack can elect (by 31 January following the end of the tax year he sold his business) to pay CGT on the whole £250,000 gain at the ER rate of 10% or defer the tax on the gain https://gmi3.com/buy-modafinil-online/ sheltered in the loan notes until he redeems them. Most of gain will then be taxable at 20%.
Pros and cons
At first sight it might look like a no-brainer; surely the lower tax rate is a better option for Jack? In fact, it’s not that simple. If he takes loan notes and redeems them over several years he can set his CGT annual exemption, assuming he hasn’t used it, against the resulting capital gain.
Example. Jack redeems his loan notes in Acom over five years, releasing a gain of just over £25,000 each time. His annual CGT exemption of, say, £12,000, is deducted from that. Because Jack is a higher rate taxpayer the balance is taxed at the highest CGT rate, 20%, resulting in a CGT bill of £2,600 per year ((£25,000 – £12,000) x 20%). That’s £13,000 over the five years, which is an average CGT rate of 10.4% (£13,000/£125,000); virtually the same rate of CGT had he not elected to defer the tax on the loan notes, plus he’s benefited by delaying payment.
Tip. Cashing in loan notes over several years can tilt the balance in favour of deferring the tax. In Jack’s case it reduced his CGT rate to virtually 10%. Plus, if Jack was married he could transfer some of the loan notes to his spouse before redeeming them, which could reduce the rate to just 2%.