Capital gains tax risk for SME entrepreneurs

Ever since the Office of Tax Simplification (“OTS”) rushed out its report on the UK’s CGT regime in 2020, business owners in the marketing services industry have been scratching their heads. Do they run for an early exit and lock in a lower tax rate now (based, potentially, on Covid-19 depressed profits) or trade on and face the music of a huge potential hike in the CGT burden?

Historical CGT rates

The current CGT environment is benign when viewed historically. Since 1980, CGT rates for business owners have see-sawed between 30% and 18%, with a period between 1989 and 2008, when CGT was calculated at (high) marginal income tax rates. After the ‘golden years’ of Entrepreneurs Relief (ER) on the first £2m, then £5m and finally £10m of lifetime proceeds, which reduced CGT to 10% on those proceeds in a company sale, rates have tracked up. ER lifetime allowance was reduced to £1m (and re-branded “business asset disposal relief”(BADR) to provide a fig-leaf for Government against accusations of anti-entrepreneurial behaviour) and the flat CGT rate raised to 20% from 18%.

OTS proposed changes

The OTS has called for greater alignment between income and capital gains (returning us back to 1989-2008 period) and that BADR should be scrapped to stop ‘bond washing’. If Rishi Sunak aligns CGT with Income Tax but keeps £1m BADR, the impact on the vendor(s) of an SME still will be catastrophic. As Jim Shaw (Shaw & Co) points out, this would take the tax burden on selling a £10m business from £1.9m today (December 2020) to £4.15m after the change, a more than doubling of the tax burden on the same transaction. Unsurprisingly, the business community have cried foul on the proposals, as it is a windfall tax on years of entrepreneurial sweat, toil and stress.

The impact on marketing services entrepreneurs will be substantial. Many businesses are sold by partners for exit prices in the £2m-20m range, where the remaining £1m ER allowance is significant and where owners tend to be in the highest income tax bracket. If we take, for example, a recent D5 Capital deal where 3 equal partners sold a business for £15m, the tax suffered was £0.9m per partner on £5m proceeds (ignoring annual CGT allowance), equivalent to an effective 18% overall burden – significant but manageable. That same transaction post the proposed OTS changes, including the abolition of BADR, would be potentially £2.25m per partner (45%) – making the benefits of the sale marginal when compared to holding the asset and taking dividends.

How will marketing services entrepreneurs respond?

For the owners of the myriad agencies and consultancies that operate in the 20 to 30 or so sub-segments of the marketing services industry, the possible changes pose a short-term dilemma and a long-term challenge. Do they go to market to bake in a teen tax rate or wait for profits to recover and pay a potentially higher rate? And if they do trade on, will CGT rates ever return to ‘acceptable’ levels?

Consider a hypothetical example. A two-partner, 50:50 agency has seen profits halve in 2020, due to Covid-19, to £1m. They receive an offer at 6x trailing profits (£6m EV). Each partner could receive £2.5m net of CGT today. But they think that they can drive profits back up to £2m over two years’ time and sell at 7x LTM profits due to the greater scale at that point (£14m EV).

The tax rate on each partner’s gain could be £7m x 45% = £3.15m if OTS’ full recommendations go through from 2021/22 onwards, making their net take £3.85m. If one then discounts the future receipt for execution risk (say 10% p.a.) we have a net present value of that deal of £3.18m per partner. Arguably a very small improvement in prospective returns.

So my conclusion is that we will see a spike in company sales in Q1 2021 for those that can hit the deadline (and who believe that the Chancellor will not remove BADR retrospectively or on the earn-out element). For those that continue to trade on, they will either seek to plan for far greater tax efficiency or wait for a more benign CGT regime. There is no question that 45% tax take from the sale of an SME is utterly unacceptable and that enjoying a dividend stream into the future will be seen as far preferable, with all the flexibility and autonomy that comes with that. So, as the Chancellor has been warned, there will be a massive slowdown in transactions and probably a fall in CGT from the £9.5bn in 2018/19, let alone from the £14.5bn targeted by OTS.

If the Government is sensible, they will re-introduce some form of taper relief to remove inflationary gains from company exits and special treatment  of share options granted via EMI schemes. For the hundreds of thousands of managers to have their EMI scheme options taxed like a standard bonus would be a grotesque ‘moving of the goalposts’ and may significantly de-stabilise management structures at SME’s that have taken years to develop and nurture. 

For businesses unable to meet the short timeframe for a sale, it is probably a case of waiting to see what the tax regime is, what the best structures are for mitigating CGT in the new environment and trading on.