Deeply discounted securities: taxation: ‘earn-out’ rights
ITTOIA05/S442 prevents a security being treated as a deeply discounted security merely because it was issued to satisfy a ‘qualifying earn-out right’. A qualifying earn-out right is where
- a person transfers shares or debentures in a company, or the whole or part of, or an interest in a business, in return for unascertainable deferred consideration, and
- the deferred consideration takes the form of a right to receive a security such as loan notes at a later date.
George and his wife Tabitha each own 50% of the shares in a small trading company, X Ltd. Each subscribed £50,000 for their shares many years ago. An established group of companies, the C group, makes an offer for the company. It is agreed that the C group will pay an immediate cash sum of £1.2 million for the company, i.e. £600,000 to each of George and Tabitha.
In addition, C plc will, in two years’ time, issue loan notes to George and Tabitha if, but only if, the pre-tax profits of X Ltd are at least £150,000 in each of the two years. Provided this condition is fulfilled, the nominal value of the loan notes to be issued will be £200,000 plus 10% of the profits of X Ltd in those two years. George and Tabitha’s right to be issued with these notes is a ‘qualifying earn-out right’.
The loan notes represent deferred consideration that is not ascertainable when the shares are sold. CG58000 onwards gives guidance on the capital gains tax treatment of these arrangements. Under TCGA92/S138A (3), the earn-out right is treated as a notional security. Suppose that the market value of the earn-out right held by each spouse is agreed to be £60,000. The base cost of the notional security held by George is therefore
£50,000 x 60,000/(600,000 + 60,000) = £4,545
At the end of two years the qualifying conditions are met and C plc issues loan notes with a nominal value of £150,000 to George. The notes carry interest, and can be redeemed at par after 12 months. The issue of the notes is treated as a company reorganisation, by virtue of TCGA92/S138A (3)(c).
However, without ITTOIA05/S442, the issue price of the loan notes would be the value of the earn-out right when it was granted, in other words £60,000. Since the notes will redeem for £150,000, they would clearly be deeply discounted securities and George would have an income tax charge on a profit of £90,000.
But this would lead to double taxation. This is because if the loan notes are deeply discounted securities, they will automatically be qualifying corporate bonds (QCBs) - TCGA92/S117 (2AA). Thus when the “notional security” - the earn-out right - is extinguished and the loan notes are issued, TCGA92/S116 (10) will apply. So a chargeable gain of £150,000 - £4,545 = £145,455 (subject to taper relief) will be calculated at the time when the loan notes are issued, and brought into charge when George redeems or otherwise disposes of them.
ITTOIA05/S442 removes this double charge. It does so by treating the issue price of the securities as the market value of the earn-out right immediately before their issue (plus any further cash consideration given for the securities).
In this example, the value of the earn-out right immediately before the issue of the loan notes is £150,000. This means that the notes are not deeply discounted securities, and no income tax charge arises when they are redeemed. The vendor’s profit on the earn-out arrangements is wholly within the CGT rules.