The client had 10% of a company he worked for. A buyer acquired all the shareholders' shares, and the terms were cash now, plus earn out payments after 1, 2 and 3 years.
The amounts of the earn out payments will be satisfied by the issue of loan notes, and prior clearance was obtained from the Revenue under s135-138 CGTA, such that the loan notes will be treated as a share-for-share exchange (ie shares realised at no gain no loss).
The question is: how do we apportion the shares disposed of between the cash receipt and each of the earn out payments? I have estimates for each of the eventual earn out payments - do we allocate the shares proportionately between the 4 receipts (1 now and 3 later)and adjust in future years as necessary?
Brian
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Brian, you're right
My mind was focused back on the days when 138A was introduced (they do say short-term memory is the first to go!), and on the ghastly consequences of not applying the section.
Of course it is true that 138A is now the default setting.
Re taper: unless an election is made to disapply it, the assumptions in 138A(3) apply. The earn-out right is treated (for the purposed of s.135) as a security of Newco, and incapable of being a QCB.
Accordingly, share-for-share occurs (i) at the time the earn-out right is acquired and (ii) at the time the right is exchanged for loan notes. As a result, there is continuity of ownership for taper purposes throughout.
Part disposal
I don't believe you do allocate the shares between the four tranches, in the sense of saying that (say) shares 1 to 3 were sold for cash, shares 4 to 6 were exchanged for the year 1 loan notes etc....
Instead, my understanding is that each share has been exchanged for a combination of cash and rights in each of the three allocations of loan notes. Which makes it a complex part disposal, and the question is what proportion of the indexed base cost of each share relates to each part of the consideration.
As it's an earn-out, the initial consideration is cash plus the right to receive a presently unquantifiable number of future loan notes.
The proportion of the base cost in each share which relates to the cash is found using A/(A + B) where A is the cash and B is the "Marren v Ingles" value* of the basket of earn-out rights. The cash element is, of course, immediately chargeable.
When the year 1 loan stock is received, another batch of base cost can be allocated to that tranche of loan notes using the formula (this time A is the value of the loan stock, B the Marren value of the remaining two tranches), etc.
Even though s.138 clearance has been given, that merely says that share-for-share is available in respect of exchanging shares of the old company for loan stock in the new company.
In an earn-out situation, the client should make his own election under s.138A to ensure that there is no crystallisation of gain on the receipt of each tranche of loan notes.
Absent the election, the receipt of a tranche of loan notes would be the chargeable disposal of a Marren right, and share-for-share deferral strictly not possible.
If he makes the election, the repeated application of the part disposal formula safely apportions base cost between the various sets of loan notes, and defers tax until they themselves are redeemed.
* The best estimate of the present value of the right to future consideration, discounted where appropriate for uncertainty and delay.