Entrepreneur’s relief (ER) can dramatically reduce the capital gains tax (CGT) triggered by the sale of a company or business. With sellers rushing to sell companies before 11th March in case the Budget restricts or even withdraws ER, now is an opportune time to consider how ER interacts with other issues at play in an M&A deal, such as earn-outs.

In an earn-out scenario, part or all of the consideration for the purchase of shares is deferred to a time after completion and it is quantified by reference to the future performance of the target company. This right to receive the deferred consideration constitutes an asset in its own right; it is an asset received for the sale of the shares. That asset is then disposed of when the consideration monies are actually paid.

The issue is that ER can only apply to the consideration received for the sale of the shares which is the value of the earn-out right, based on an estimate of the deferred consideration, and any cash received on completion. This means that, if the deferred consideration has been underestimated, the excess over the earn-out value (as estimated at point of sale) will not attract ER as it will be consideration for the disposal of the earn-out right, not for the disposal of the shares.

There are however ways to structure an earn out so that the consideration is deemed to be deferred or contingent, as opposed to unascertained, thus making ER applicable to the whole amount.

Action

Lawyers should advise clients considering a sale with an earn-out that careful structuring is required to preserve ER on the full consideration received.