With cash in scarce supply, loan notes provided an excellent method of deferring the cost of buying a company. But recent changes in tax laws mean that they are now less appealing and holders of existing loan notes are likely to be in for a nasty surprise.
If there is one consistency between the previous government and the new coalition government it is that both love to meddle with the capital gains tax (CGT) system. While the changes announced in the Emergency Budget on 22 June 2010 to the Entrepreneurs’ Relief (ER) lifetime limit and the CGT rate were well publicised, the impact of the budget on loan notes, both existing and new ones, is more complex, and relatively hidden in the budget announcements.
What are loan notes?
In simple terms, a loan note is a form of deferred payment often used in today’s cash-strapped economy to enable purchasers to buy a company, but pay only a proportion of the cash proceeds upfront. In addition to the cash proceeds, the vendors receive loan notes, which are redeemable at a future date for the remaining proceeds.
Loan notes are either ‘qualifying corporate bonds’ (QCBs) or ‘non-qualifying corporate bonds’ (non-QCBs) from a tax viewpoint. QCBs were seen to be ‘normal commercial loans’ as far as HM Revenue & Customs was concerned, but the full deﬁnition of these is outside of the realms of this article.
Before 6 April 2008, the legislation sought to ensure that, where a gain arose on a transaction but the vendor received shares or debentures rather than cash proceeds, the gain arising could be held or rolled over so that no immediate CGT was payable on that element.
On 6 April 2008, the switch to ER heralded an important split in tax treatment between QCBs and non-QCBs. From this point onwards, if you received non-QCBs you could no longer have your cake and eat it – the cake in this instance being rolling over your capital gain.
If you chose to roll over the gain it is highly likely that you would no longer be able to claim ER when the gain came back into charge. The only way to safeguard your ER on your non-QCBs after this date was to elect to not roll over the capital gain, but instead pay the resulting tax liability upfront.
However, the position for QCBs was different, and meant that as long as your loan notes were QCBs, you could hold over your gain and still claim ER when the gain crystallised.
Changed tax position
As part of the measures which came into effect on 23 June 2010, the tax position for all types of loan notes was more or less aligned. Now if you receive any kind of loan note, you have the difﬁcult choice to make between rolling/holding over the capital gain and losing the ER due on the original shares, or electing to receive your ER and paying the tax due at the point of the transaction.
With ER now worth a potential £900,000 per individual, this is not an easy decision.
Should you choose to make the election, you would need to ensure that you have sufﬁcient cash available to be able to pay the tax liability arising. This is particularly important where non-QCBs are involved as the election applies to the whole transaction, not just the element relating to the loan notes. So, if you received new shares in exchange for your old shares as well, you need to be prepared to pay tax on those, too.
The alternative is to structure the deal so that you retain a sufﬁcient shareholding (and continue to be a qualifying shareholder) so that when the loan notes are redeemed you still qualify for ER overall. This could be a risky strategy given the uncertainty over the future CGT system, and means you have more of your cash still invested in the business than you might like.
The future of loan notes is now very much in question when the tax consequences are so unfavourable.
So, what if I already have loan notes?
If you have received loan notes in the past few years and received tax advice at the time of receiving them, you could be forgiven for thinking that you are well aware of the tax you will pay on their redemption. But you could be wrong…
If you received QCBs in the period 6 April 2008 to 22 June 2010…
…you would have been able to hold over the capital gain arising on the share sale into the loan notes. You may be expecting that when you redeem these loan notes you will pay 10% tax on the proceeds up to the ER limit in force at the time of the original disposal. In most situations this will no longer be the case. The old method of calculating ER meant that the deferred capital gain due ER was reduced by 4/9ths, such that when the gain crystallised and was taxed at 18% it would have an overall effective CGT rate of 10%. Now that the CGT rate for higher and additional rate taxpayers is 28%, this is the rate that will apply against the reduced, held over gain, giving an overall effective rate for the element entitled to ER of 15.6%. This is a 56% increase in the tax you may have been expecting to pay.
If you received QCBs before 6 April 2008 and partially redeemed them before 23 June 2010…
…the same problem arises. In this case, the remaining gain entitled to ER after the partial redemption was reduced by 4/9ths which, when now coming into charge, will be taxable at 28% for higher/additional rate taxpayers, again leaving an effective tax rate of 15.6%.
Those who exchanged shares for QCBs before 6 April 2008, and who have not partially redeemed them in the period 6 April 2008 to 22 June 2010…
…can breathe a sigh of relief. The transitional provisions mean that these loan note holders will receive ER at the 10% rate, and potentially up to the new £5 million individual limit.
For those with non-QCBs received before 6 April 2008…
…it is still bad news as your position has not changed and you will not be able to claim ER unless you qualify for ER through holding a qualifying shareholding in the same company.
Words: Nadine Elliott, Senior Tax Manager