DealMakers - Q1 2023 (released May 2023)
The sale of business interests
by Angelique Stronkhorst and Bobby Wessels
In the current economic environment, and in pursuance of various commercial goals, business owners frequently sell their business interests.
The sale of shares in a business, whether to reinvest in a more profitable business, withdraw one’s interest from the business sector, or simply sell the interest to one’s best advantage, can be structured in various ways.
From a tax perspective, the capital gains tax consequences arising from the disposal of a business interest (i.e., the disposal of shares) become relevant. Several variations of sale agreements can be entered into with the consideration being received by the seller at different stages of the transaction, depending on its nature and content. This article will focus specifically on the tax consequences that will be incurred depending on the timing of the receipt of the consideration.
Receipt of proceeds on the date of sale
From a tax perspective, the disposal of a business interest will typically be deemed to take place once all the suspensive conditions have been lifted. Therefore, where a business interest is sold and the seller receives the full proceeds (the con-sideration) in the same year, capital gains tax will be payable in the year of assessment in which the asset is disposed of.
In considering the amount of tax to be paid, the identity of the holder of the shares should be considered. The sale of capital assets by a company attracts capital gains tax at an effective rate of 21.6%, which is slightly higher than the effective rate of 18% applicable to individuals but lower than the effective rate of 36% pertaining to trusts. Typically, however, in the context of a trust, the capital gain can be distributed to the beneficiaries of the trust and, therefore, taxed at the marginal tax rates of those beneficiaries, which in the case of natural persons will, again, be 18%.
Receipt of proceeds over time
The sale of shares that is subject to a suspensive condition can only be said to be disposed of once the underlying conditions are all met. Where all the conditions are met in year one but the consideration is payable in annual instalments over a period of, for example, four years, tax will remain payable on the full amount in year one. This is so because the suspensive conditions underlying the agreement would have been met and, therefore, irrespective of when the consideration for such disposal is received, the full tax amount will be due in the first year of assessment.
The receipt of consideration in instalments over time does not suspend the capital gains tax consequences where all the underlying conditions of the agreement are met. Accordingly, because the tax is triggered on the entire proceeds in the first year, it could potentially lead to cashflow problems for the seller while the balance of the proceeds remain outstanding.
On the contrary, where a portion of the proceeds of the transaction is subject to a suspensive condition which will be fulfilled over time, the capital gains tax will likely become payable in differing parts. For illustrative purposes, let’s assume that some conditions are required to be met in year one, after which 70% of the consideration is payable, with the remaining 30% to be paid in year two, upon fulfilment of further conditions. In this scenario, capital gains tax will be payable on 70% of the consideration upon fulfilment of the stipulated conditions for year one, with capital gains tax being payable on the remainder in year two, provided that the remaining conditions are met. In this scenario, typically, the cashflows and the tax liability will be aligned.
Receipt of proceeds: initial and contingent consideration
Where the sale of shares is subject, in part, to an earn-out-clause, the capital gains tax consequences could be spread over multiple years of assessment. In such instances, a portion of the proceeds will be fixed, with the remainder portion being subject to variable metrics.
Should the fixed consideration received in year one be less than the base cost of the shares, a capital loss will be realised; however, the remainder portion of the proceeds does not accrue to the taxpayer in the same year of assessment. Accordingly, the capital loss determined must be disregarded and can only be taken into account in future years of assessment, once a capital gain is realised on the disposal of the asset as a whole. If, after all the proceeds have been settled, no capital gain is realised, then the capital loss can be utilised in the same year of assessment against other capital gains.
As is demonstrated by the above examples, there is often a mismatch between commercial and tax considerations underlying transactions. Often times, there is a general misunderstanding that the payment of the tax will coincide with the receipt of the sale proceeds. This is not always the case and, therefore, care needs to be taken in the conclusion of sale transactions to ensure that there is no mismatch between the tax payment and the receipt of the cash proceeds. Alternatively, where such a mismatch cannot be avoided commercially, planning for the cashflow to settle the tax liability timeously will be extremely important.
Stronkhorst is a Consultant and Wessels a Manager in Corporate and International Tax | AJM.