If a contracting company is sold for an agreed price of £800,000 - 100% of the shares are sold - but, by prior agreement between the vendor and purchaser, £200,000 is left in the company bank account, so in effect the "sale price" is "inflated" by £200,000 to cover the "cash at bank", would the full amount of £800,000 qualify for entrepreneurs' relief, or should the claim reasonably be reduced?
The company has no other assets, and realistic working capital required is only about £10,000.
I ask this question because if the full amount does reasonably qualify for entrepreneurs' relief, it seems that a 40% tax-paying director can just leave all his "what would have been dividend income" in the company for a few years, accumulating in the bank account and adding to the final sale price, and only pay 10% tax on it at the end of the day. That doesn't seem reasonable to me.
Any views?
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Am I missing something here?
Assuming this is an arm's length transaction, the purchaser and seller both think £800K is a fair price for all the share capital. In which case (assuming it qualifies as a trading company) the assets and liabilities are irrelevant, and (again assuming the shareholder qualifies) entrepreneur's relief is available.
The question I think is whether the extent of the surplus cash prevents the company being a trading company for ER purposes.
If it sold to an unconnected third party it works just fine.
The unconnected third party is not going to pay £1 for each £1 of cash in the company though are they? Because for every £1 of cash in the company, they might only get 61.9p in their pocket when they take it out.
So I will take your company that is worth £800K, and if you leave £200K cash in there, I will only pay you £920K for it.
If the vendor is connected, this will fall foul of the transaction in securities rules and the entire £1,000K, less the cost of the shares, will be liable to income tax as a dividend.
Does that seem more reasonable, now that someone else has applied their brain to the problem for you?
The question is whether or not the gain would be apportioned. The answer is no - either ER is available or it is not.
Portia makes a good point, but it may depend on who the buyer is. It is common for a corporate purchaser to pay £ for £ for the cash, since they can transfer that, tax-free, to the purchaser to finance the purchase. Or if the cash is required to provide working capital for the ongoing business, there is no extraction (or need to inject cash from taxed income) so again it would be usual to pay £ for £.
If it does not need the cash
then it is surplus to working capital. You therefore have 25% of the company's assets that are being held as an investment of the owner (which is what you are saying). I think HMRC could have an issue with allowing ER on the shares as the owner's investments are more than 20% of assets although this scenario does not pop up in their manuals.
On a practical level it is fairly unlikely to be ever picked up on as the sale is to a third party and HMRC would need to know what was in the sale agreement and scrutinise the accounts in order to work out what was what. Of course they could chose to investigate the return on a random basis, or maybe they might decide to look at all ER claims one year. Sounds like that as a policy could be quite fruitful.
Yes indeed it is either a trading company for ER purposes or it isn't. But at what point does the level of assets surplus to the requirements of the trade stop it from being one?
I think that is the question that the OP is asking,
There is a 20% rule of thumb is there not?
PS (EDIT) I am glad to see that Nichola has now answered the question, and confirmed that the OP's fears are well founded.
So we have an isolated 20% of assets test now? And forget all about income and management effort?
And if you check the law you will find that a company is a trading company if it carries on trading activities and its activities do not to a significant extent include non-trading activities.
Having a big bucket of surplus cash on the balance sheet is not really an activity, is it? The cash might be excluded assets for BPR purposes, but that is a different issue.
@ Ruddles Even if I were a corporate purchaser I still would not be prepared to pay £1 for each £1 of cash.
Because I would know that the only reason I was buying the cash was so that the vendor could only pay tax on it at 10%, rather than perhaps 32.5%.
So I would probably not go above 85p for each £1 of cash. It has to be worth my while or I do not want to help the vendor out by buying the cash.
What I am curious about is what contracting activity, that needs no assets and only requires £10,000 of working capital, is worth £600,000? (£800,000-£200,000 cash)
Must have great customer
Contract cleaning - it just needs the wages in the bank.
Must have great customer base to have no debtors.
The fact there are
Net debtors and creditors is approximately zero.
The fact there are debtors and creditors possibly allows a reasonable argument as to why the business requires to keep a balance at bank of far more than £10,000 as working capital; say a significant bad debt(s) where the creditors are still payable but not all debtors are recoverable.
Any business that has its trade worth £600k as a cleaning contractor has to have a fair turnover and a fair level of staffing to justify such a valuation, accordingly £10k just appears somewhat negligible in the context of the implied turnover/ profits re the price tag supplied, so if your numbers are real this would be an area I would explore.
I guess it depends on how friendly the parties are (and/or how keen the purchaser is) - more often than not both parties are happy to do whatever it takes to minimise HMRC's cut on the deal, regardless of which party actually makes the saving, provided that one side isn't disadvantaged in favour of the other.
We have seen lots of these deals where price was adjusted £ for £ because both parties may benefit - albeit the purchaser has to wait to see the benefit through the increased base cost in shares (assuming that subsequent disposal is chargeable). Even if there is no such benefit to the purchaser he is unlikely to be disadvantaged either.
The only immediate downside is an increase in Stamp Duty for the purchaser but it tends to be such a trivial amount that it is disregarded. Yes, the purchaser may try to agree a discount on the purchase price to reflect the vendor's tax saving, and why not, but in my experience that tends to be very much the exception.
So, I suppose we have the usual difference between hypothetical and real-world cases.
Personally I still think the 20% test is a red herring here.
Does it generate more than 20% of its income from its big bucket of cash? I doubt it.
Does its management spend more than 20% of its time stirring the bucket of cash? I doubt it.
Do its activities include activities other than trading activities to a substantial extent? I doubt it.
I agree with Portia
A strict numerical analysis is unlikely to be appropriate here. And even if it were, we have new (but still insufficient) information that could alter that analysis - the asset part of the test looks at gross assets, so if debtor balances are substantial, the cash balance could become even more of an irrelevance.
Well, to play Devil's Advocate
And while still in agreement with Portia, if as you say debtors equal creditors then you have £100k of debtors. Paying off creditors leaves you with cash of £100k and debtors of £100k. So cash = 50% of assets. A little more than the 20% target. Of course, one needs also to take into account goodwill, which in this case would appear to amount to £600k (or is it £800k?). In which case, I'd agree that cash is likely to be less than 20%.
And what do you mean by paying off creditors "in effect"? They are either paid or they are not.
Although it is still all pretty academic because, like Portia, I don't think it is an issue.
not assets
Tests are on activities (income/Management time/costs) not an arbitrary 20% of assets (which is BPR) make up of the balance sheet.
If ita all surplus cash from the trade then it is absolutely not a problem. It can even be managed as long as those activities are not "substantial"
No debtors or debtors?
how we have go from no debtors to £100k debtors defeats me. I am out.
Before I go I want to qualify my response. I appreciate that some people take a view that accruing cash is not an activity. I think that it can be held to be an activity. It requires a non-dividend, possibly low remuneration strategy. For example, if a company is set up to be a savings vehicle for its owner, and that is what drives both owner and company, with the aim of building up a lot of cash and then securing ER then its activities could possibly be viewed as substantially non-trading activities. This has not been tested by the courts and it would be interesting to see what a judge might say. Having seen over recent years the way in which the tribunals and courts deal with tax schemes, you can see that this is the sort of thing that could be argued in different ways, until the cows come home. HMRC's manuals are sufficiently woolly on these points, admitting that "there is no simple formula" (see http://www.hmrc.gov.uk/manuals/cgmanual/cg64090.htm ) so don't get too stuck up on the 20% tests.
HMRC website
See CG64090 that Nichola has provided a link to. Last sentence in 1st paragraph.
Fictitious?
If you think assets is not one of the tests HMRC refer to you need to look at the link again. It is in fact the second one they mention. But it's not a hard and fast rule. I called it a "rule of thumb". It's just one of a number of factors, all of which are rebuttable. All the points you make are no doubt useful rebuttals to have available against the day when HMRC along and say that the company is not a trading company for ER purposes. If the cash is not surplus cash at all that takes the wind out of their sails immediately. But if there is surplus cash of £200k and the whole company is selling for £800k it's more than 20%, but obviously much less than 20% in terms of management input and profit contribution.
My take
I think everyone is agreed that looking at assets alone - cash or otherwise - is not the way to go. However, it is a simple truth that a large cash balance can never aid the insubstantial investment activity argument - at best it will be ignored and not influence the argument either way.
It is the legislation that refers to substantial investment activity, without any definition. HMRC have set out how they interpret the legislation but that guidance is no more than that - ultimately, if there is disagreement, it will be for the tribunals and courts to settle the argument. HMRC's use of assets as one of the benchmarks is no more authorative than the arbitrary 20% figure itself. So, simply accept the fact that if you have what HMRC consider to be pointers towards non-trade status then you may need to be ready for an argument. There is no-one here that is going to be able to give you a conclusive answer as to whether the company is or is not trading for ER. We may all have our opinions on what arguments we would put to HMRC, but that is about it.
The Duck Test
Kevin Slevin wrote an interesting article on this issue in Taxation Magazine on 7 November 2012
http://www.taxation.co.uk/taxation/Articles/2012/11/07/295881/duck-test
And the nature of the asset base is listed as one of the factors to be looked at in considering activities.
???
I don't believe that the real question has been asked yet.
If debtors and creditors are both roughly £100K why are the creditors so high in a business that would appear at first sight to have wages as by far the largest expense item.
Are most of the creditors Director loan accounts?
Why all the focus on creditors?
I don't believe that the real question has been asked yet.
If debtors and creditors are both roughly £100K why are the creditors so high in a business that would appear at first sight to have wages as by far the largest expense item.
Are most of the creditors Director loan accounts?
Plenty of reasons.
Maybe its corporation tax + final VAT + PAYE + trade creditors + DLA?
I have heard
That if the accumulated cash has come from historic trading activity then HMRC are happy to ignore it re 20% test, but simple planning can be done to reduce any risk here.
Yes - like I and everyone else keep saying it's a rule of thumb, guide, general indicator - call it what you will - not a hard and fast rule. Not sure what point you are making.
Oh dear. Assets is one of a variety of measures that the 20% test is applied to, Full stop. That is simply a matter of record - on the HMRC website, for what it is worth, - and referred to a number of times by me and others in the above thread in order to assist you.
What is the point you are trying to make?
You just said that there was no 20% of assets rule, which is clearly the opposite of the truth, so why do you keep repeating it?
Meaning "rule" as loosely defined of course - not hard and fast but one of the factors HMRC say should be looked at and taken into account. Why do you keep asserting that they don't?
Is your point that HMRC's reference to assets is not a "rule", but something else?
Or is your point that HMRC make no reference to assets being relevant at all?
Because I've been (mis)quoted
The issue here seems to be one of semantics. There is in fact no 'rule' at all. The only 'rule', if one insists on using that term, is the legislation that refers to substantial non-trade activity. HMRC have set out how they interpret that legislation, making the point that the value of non-trade assets on (and/or off) the balance sheet is one of several factors that may need to be taken into account. I'm at a loss as to why this has generated so much discussion.
Exactly
The issue here seems to be one of semantics. There is in fact no 'rule' at all. The only 'rule', if one insists on using that term, is the legislation that refers to substantial non-trade activity. HMRC have set out how they interpret that legislation, making the point that the value of non-trade assets on (and/or off) the balance sheet is one of several factors that may need to be taken into account. I'm at a loss as to why this has generated so much discussion.
Exactly. I don't disagree with a word of this, which of course is only what has been said several times previously in this thread, by me and others. There has been no disagreement about it, so I too am baffled as to why the thread has become so long.
Yes but...
What we need in these threads is somebody to have the last word. Why do you not say something final sounding John?